Roger Cuddy

The term moral hazard is seen often right now in commentary directed towards bailouts of industries or individuals. While used often, it is explained rarely and anyone who without education in economics can easily be left with only a partial understanding of what is meant. I’ll attempt to explain the meaning in the current context in a succinct manner.

Moral hazard simply means that a person or business that is protected from the negative consequences of an action may behave differently than if they were not. Consider a state lottery or as my kids refer to it ‘the stupid tax’. The chances of a positive outcome are so skewed that no one understanding the odds would waste the time or money to purchase a ticket.  Now, what if at the end of the month you could turn in losing tickets for a refund? The situation has now been changed so that the best outcome for an individual would be to expend their entire wealth on purchasing tickets each month since the risk has been removed.

Obviously no state is going to give back the money it managed to extract from it’s less informed inhabitants so l will move on to a more feasible example.

Consider the case of a young person working for company X.

• The young worker is in line for a promotion which would come with a 20% increase in salary.
• Real Estate prices have been rising rapidly for the last few years
• They have seen many articles recently reminding them of how much money is being ‘wasted’ by renting.
• The economy seems to be slowing down and if it gets any worse the promotion won’t happen.

Being a diligent sort by nature the young worker calculates the maximum mortgage payment they could afford both ways, including the promotion and excluding it. They feel the safe course would be to limit any mortgage to what is affordable even if the promotion doesn’t come through and most of us would probably agree with that. However, what if in the last real estate downturn the government had stepped in an limited mortgage payments so that they were had to be revised to match the owner’s income? If the person in this example feels that is likely to happen again then their best interest might be better served with the more expensive mortgage. If the economy tanks and the promotion doesn’t come through they can count on their payment be forced lower to match their income. In this case their behavior has been influenced by a belief that they are protected from the negative consequences of choosing a mortgage they might not be able to afford.

Adding a business example to the above would be the case of a CEO for a firm issuing credit insurance. If the CEO believes the government will step in to cover any catastrophic losses then he is going to have company take much more risky bets than otherwise. Note that in this case there is also the agent issue to worry about since the best interests of the shareholders may well not align with the best interests of the CEO. In fact that seems so common currently that I often wonder if we need to rethink corporate governance completely.

This was a very brief introduction to the topic of moral hazard and there are plenty of places around the web you can look for more in-depth examples and explanations if you wish. Wikipedia has a decent write-up to start with for further study. As we add more economic content to this site we may also come back and flesh out this small text also.