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How Big a Problem is Moral Hazard?

Megan McArdle with an interesting point of view on moral hazard and the current crisis.

The sticking point for me is twofold.  The first is that we had crises before there was moral hazard–really, really dreadful crises, crises far worse than the one we’re having now.  I just don’t see how you can look at the 1930s and name the FDIC as the decade’s biggest financial problem.  Or this decade’s biggest financial problem.  The closest our era came to a really devastating financial crash along the lines of the 1929-1933 period was in the total unguaranteed institutional money market funds.

Nor do I find the central story of how the FDIC induced this moral hazard very compelling.  Supposedly, ordinary depositors don’t bother to check the soundness of their banks because they don’t actually have skin in the game. 

Anyone making this argument cannot have met many ordinary depositors.  If you stripped away my mother’s FDIC protection, she wouldn’t do any better of a job at evaluating Citigroup’s finances.  Moreover, this theory simply cannot explain the waves of bank failures that happened before 1934–failures in which the depositors neither expected, nor received, bailouts.  Bankers still got overconfident, lent too much, and then went out of business.  If you read contemporary accounts like the Benjamin Roth diary I recommended the other day, it’s very clear that even when the shareholders and depositors were prominent local businesspeople with a lot of skin in the game and a pretty intimate knowledge of the bank’s circumstances, they were still unable to foresee the trouble the banks got into.

The other reason that I don’t find it all that compelling is that I went to business school with these people, and talked to them when they were at the banks, and the operating assumption was not that they could always get the government to bail them out if something went wrong.  The operating assumption was that they had gotten a whole lot smarter, and would not require a bailout.  Maybe this had some effect on the margin.  Maybe it even subtly percolated into prices, and thereby, everyone’s consciousness.  But that is not a big enough effect to explain the whole thing.

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