Tuesday, January 5, 2010

Summers' on Moral Hazard

Via the Baseline Scenario (hattip to commenter on this blog).

In larry's Ely Lecture in 2000, he said "[I]t is certain that a healthy financial system cannot be built on the expectation of bailouts..."

Yep, that's why Lehman failed, they just knew they'd get bailed out.

The basic problem with worrying too much about moral hazard is this: suppose I wanted to prevent you from doing some kind of bad behavior, such as eating candy bars. As punishments, you could be fined $100, or have your house blown up with a nuclear weapon. Of course, a $100 fine is probably enough to get you to not eat candy bars if you can help it, w/ the added benefit that it won't also have lots of collateral damage. This isn't a great analogy for finance, but most firms weren't really aiming to go bankrupt and I don't think getting bailed out really enters into their thinking about how they trade. Regulating pay and higher capital requirements would do much more to alter behavior...

3 comments:

  1. It seems really interesting to me. I am bit curous to read the larry's Ely Lecture. Can you post it or give me the link from where I can read it.

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  2. Good point on the pre-bailout Wall St mentality; however, it's now relevant. Due to Summer's damage, which might describe so much of his work.

    The reality of course is actual much more damaging to the neoliberal/neoclassical ideas. It seems to have come down to the fact that the people making decisions in these firms were very rational, and figured that "Heads I'm rich, tails I get a golden parachute" deals were optimal. For them.

    The stockholders didn't know, and probably had no way of knowing; the various market participants (accounting firms, rating firms) were totally involved in the corruption and lies.

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  3. It's true that most firms don't do business believing that they will need to be bailed out one day (and the bailouts are usually onerous in some way, e.g. Bear Stearns at 10, the banks rushing to repay TARP). However, the possibility of bailouts can still affect behavior at the systemic level - make firms do things they wouldn't do otherwise, even if they consider themselves to be safe. For example: when Lehman went under, one of the money market reserve funds had invested in Lehman bonds and would "break the buck", which was feared to lead to a general run on money market funds - so the Fed stepped in and guaranteed it. Another example: lots of financial firms knew that CDOs, debt-laden firms, etc were risky. So they did the prudent thing and bought some insurance in case things went wrong... from AIG. If they knew that their source of insurance itself had a nontrivial risk of failure, maybe a whole range of activities would become non-insurable and hence not take place.

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