Moral Hazard

by Luke Muehlhauser on April 21, 2011 in Ethics,Guest Post

Today’s post on ethics is written by Alonzo Fyfe of Atheist Ethicist. (Keep in mind that questions of applied ethics are complicated and I do not necessarily agree with Fyfe’s moral calculations.)

cloud_break

 

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.

Wikipedia, Moral Hazard

I have heard this claim a number of times – a person dismissing claims that he or she should be more careful because “I’m insured” or “It’s not my car, it’s the company car” or “I don’t have to eat it.”

It’s like buying a lottery ticket every week, and having a friend say, “If you win, you keep all the money. But if you lose, I will buy the losing ticket from you for 90 cents on the dollar.” Now you have an incentive to buy a lot more lottery tickets. You have an incentive to take a lot more risks. You have an incentive to generate far more losses and to impose those greater losses on the person who is buying the ticket.

The ticket buyer would be foolish to assume that your lottery ticket purchases will remain constant after he makes this offer. Perhaps it will, but, all things being equal, there is no good reason to believe that it will be.

In some cases, moral hazard generates significant costs.

Moral hazard is said to have been a significant cause of our current economic problems. The government has long displayed a willingness to step in and rescue businesses and institutions in financial distress. From the Chrysler bailout to the rescue of the Mexican government to Long Term Capital Management in 1998, investors have had reason to believe that, while they will be able to keep any gains from their risky investments, the government will step in to cover the losses.

As a result, large investment institutions took risks – or at least failed to exercise cautions – that they probably would have avoided if not for the government’s implicit promise to cover the downside risk. When the government actually allowed Lehman Brothers to fail in September of 2008, people who had invested in financial institutions expecting the government to protect their downside risks suddenly panicked. Faced with the prospect of suffering the true costs for foolish decisions, they suddenly wanted to put their money someplace else.

The government responded by covering this downside risk – bailing out AIG and other companies, allowing investors to breathe a sigh of relief that they can continue to take risks and the government (taxpayers) will continue to cover their losses.

Besides, the CEOs and others responsible for these choices have paid very little for their mistakes. instead, they have passed significant costs on to others.

Moral hazard increased the harms suffered as a result of Hurricane Katrina, as well as the recent tsunamis in Japan and the Indian Ocean (though less so in the latter case). There was never any doubt that, after such a disaster, governments would step in to cover at least some of the downside costs that these risky behaviors might generate.

Granted, it is not the case that 100 percent of the downside risk was covered. Many people lost more than any government relief and rebuilding efforts can ever give back. The worst among these are those who lost their lives. Still, some of those who would have died might have been living in a safer place if the promise of some sort of bailout was not promising to cover a substantial portion of the downside risk.

Living on the coast is a risky proposition. But people who do so, particularly in developed countries, know that they can expect significant government handouts if they gamble and lose. So, they have less of an incentive to avoid those costs. As a result, the corresponding costs are greater than they would have otherwise been.

Now, do not accuse me of making the absurd claim that these bailouts always cover all costs and, thus, eliminate risks. In the case of wealthy corporate executives bringing global economies to their knees this may be close to the truth. But it clearly does not apply to all of those who accept the risks posed by earthquakes, tsunamis, and other natural disasters.

Still, to the degree that governments and other institutions – including insurance and charitable institutions – reduce the downside risk, to that degree they reduce the incentive to avoid those risks, and to that degree these disasters become more likely and more costly when they do occur.

Moral hazard is relevant in the subject of global warming. Those who are saying that there is little or no risk to increasing greenhouse gas emissions are, to a large degree, not the people who are going to suffer the consequences if they are wrong. It would be quite nice if we could say to these people, “Fine. If you believe that no harm will come from greenhouse gas emissions, then go ahead. But if you are wrong, the costs will come out of your pockets.” I suspect that a lot of global warming desires would suddenly find themselves urging some degree of caution. “Well, maybe nothing will happen, but let’s not risk my retirement account and mansion in the Colorado Mountains on the possibility.”

When the costs of these actions can be transferred to others – particularly to poor people in foreign lands or future generations, both of which have little or no chance to pass their costs onto us – the problem of moral hazard comes into play.

Health care is another area where moral hazard increases our costs. People are not held responsible for decisions that affect their health. If they take a risk – of diabetes, lung cancer, heart attack, stroke, throat cancer, sexually transmitted disease – a part of the cost of that risk is borne by others. This decreases the incentive to avoid those risks, and increases the total cost of medical care for everybody.

Ironically, because of this moral hazard, one of the effects of promoting a national health insurance may be to give people less of an incentive to avoid risky behaviors that ultimately reduce the quality of their health, demanding that more money goes to covering (avoidable) health-care costs.

Certainly, there are other costs associated with these risky behaviors that cannot be passed on to others, but it remains the case that covering a portion (but not all) of a person’s costs will reduce (but not eliminate) the incentive to avoid those costs, meaning that more costs will be generated for others to cover.

There is a reason to consider personal responsibility a moral virtue. Through advocating personal moral responsibility, we create a culture that can avoid, to some degree, moral hazard and the costs that it generates.

However, it also has its downside. Turning everybody into a cold and callous individual who is indifferent to the welfare of their neighbors carries its own down-side risks – risks that are not going to be borne entirely by those who are or who become these cold and callous individuals.

- Alonzo Fyfe

Previous post:

Next post:

{ 10 comments… read them below or add one }

MKR April 21, 2011 at 4:29 am

Moral hazard increased the harms suffered as a result of Hurricane Katrina, as well as the recent tsunamis in Japan and the Indian Ocean (though less so in the latter case). There was never any doubt that, after such a disaster, governments would step in to cover at least some of the downside costs that these risky behaviors might generate.

What does the writer mean to refer to by the phrase “these risky behaviors”? Living in such places as Japan, the South Pacific, or New Orleans?

  (Quote)

Lorkas April 21, 2011 at 4:42 am

What does the writer mean to refer to by the phrase “these risky behaviors”? Living in such places as Japan, the South Pacific, or New Orleans?

I had the same double-take. From the stuff following it I think he means “living near the coast” and “living in an area where earthquakes are common”. It’s still a kind of strange point though.

  (Quote)

Zed April 21, 2011 at 5:59 am

Although I accept that there is some correlation between incentives and behavior, and between risk and behavior, I think the conclusion you draw does not follow from the examples you’ve given. In particular I take issue with this part:

Still, to the degree that governments and other institutions [...] reduce the downside risk, to that degree they reduce the incentive to avoid those risks, and to that degree these disasters become more likely and more costly when they do occur.

For this to be true people would have to have an accurate perception of the risk, assess risk distributions correctly and act rationally on that data. It presumes that there is a “perfect free market” for systemic risk.

Health care is another area where moral hazard increases our costs. People are not held responsible for decisions that affect their health

In most of Europe (Sweden/Denmark/France/Germany) healthcare is great and citizens bear almost no personal risk. Do they therefore live unhealthier lives because they would get “subsidized” if they did? No. They don’t. In fact, it’s in the USA with its atrocious health care system where people take terrible health decisions. It even applies within the USA. Do you generally see richer people (who are better insured) take worse health decisions than middle-class or poor people? Nope.

Only in a few scenarios do people act correctly based on loss/gain incentives. Game theorists and people who study cognitive biases have covered this in depth. You simply can’t model people as rational agents, and especially not for scenarios where people can’t learn from experience (if people lived 10 times, you could expect them to learn that bad habits lead to health problems later in life / if people lost 10 houses in 10 Katrina’s you’d expect them to learn that living near the ocean can be dangerous / etc).

  (Quote)

mister k April 21, 2011 at 6:14 am

Do we know that people won’t continue acting irrationally without govt protection? In particular if the govt decided it was going to refuse to help those who were flooded, would we anticipate the coasts being empty? We’d probably anticipate, in such a scenario, private companies covering risks with insurance, so only wealthy people could afford to live on the coast.

Moral hazard certainly exists, but I think you underestimate humans inability to accurately assess risk. I think humans will indulge in risky behaviour provided the risks are long term and seemingly small- this has been a trend in the financial sector even when it was not certain the the govt would protect those people at risk. The reason the govt stepped in to save gigantic banks was because they were, distressingly, too big to fail., I agree that being in a position where we are unable to punish failure in financial institutions is extremely important, but I’m not convinced its wise for the govt not to save anyone on an individual basis just to maintain a principle.

  (Quote)

Jeff H April 21, 2011 at 12:34 pm

I agree with Zed on this one. While certainly it is an exercise with some merit to discuss the effects that subsidizing risk can bring to rational actors, it’s important to remember that humans are not always rational actors. It’s the economics vs. behavioural economics problem here. People are terrible at assessing risk, with the risks often either overblown or underplayed. (In Canada, a major election promise by one of the parties is to crack down on violent crime, despite the fact that crime has been on the decrease. The risk has been dramatically overblown in this case.)

Still, all the same, the point is a good one. People who don’t have to deal with the consequences are more likely (all else being equal) to engage in risky behaviour. And perhaps in some cases, the warning of risks will lead people to make a more thorough assessment of the risk. We just have to be wary of generalizing this without also acknowledging the irrationality that is present in real-life situations.

  (Quote)

Kevin April 21, 2011 at 1:04 pm

“However, it also has its downside. Turning everybody into a cold and callous individual who is indifferent to the welfare of their neighbors carries its own down-side risks – risks that are not going to be borne entirely by those who are or who become these cold and callous individuals.”

Here’s the catch 22. Perhaps you’re familiar with this story: http://www.youtube.com/watch?v=dJyjNiL4zZg. What is the best response? Does putting out the fire create an incentive that encourages people to take more risks and let others pay for the negative effects? Or should we let those who take risks and expect others to assume the costs to lose everything? After all, isn’t charity a virtue on desirism? Couldn’t we simply consider rebuilding disaster areas an act of charity, since they are in the same position as those who need charity? If so, wouldn’t simply being charitable take precedence over squabbles of who is going to pay for bad gambles?

  (Quote)

anonomous April 21, 2011 at 9:06 pm

Hey Luke, you should review the “Carrier and JP Holding” review.

  (Quote)

Keith J. April 22, 2011 at 10:56 am

At first I thought that “AIG” was for Answers in Genesis! HAHAHA. Another moral hazard…

  (Quote)

mojo.rhythm May 9, 2011 at 7:27 pm

What I want to know is:

Why the HELL is Wall St not in jail? They single handedly brought down the economy with their revolting speculation, deregulatory lobbying and short-sighted shenanigans. The only bankster that was put in the pen is Madoff; the reason being that he ripped off other rich people! What did Obama do to fix the crisis? Well he hired the same people who caused the dastardly meltdown in the first place!

Jesuuuuuusss….CHRIST!

Is anyone as frustrated about the whole thing as I am?

  (Quote)

Zeb May 10, 2011 at 5:02 pm

I am mojo! I seriously think they should be tried for treason, and the definition and burden of proof for that charge should be rigged to fit what those fucks did. They fucked our entire nation for personal profit, and then attempted (successfully) to hold us hostage so that the government would have reason to bail them out and they could keep getting bonuses. I’m a pacifist anarchist, but these guys really tempt me to wish for some French and/or Bolshevik revolutionary consequences for them personally.

  (Quote)

Leave a Comment