Why the Moral Hazard Argument Fails

Ok, this post should be more accurately titled, several reasons why the moral hazard argument fails.  So the progenitor of this post is a July planetmoney podcast about the financial reform act.  I'm not going to rehash the podcast.  Listen to it yourself.  One of the contributors stated the argument for moral hazard.  Namely, if bad behavior isn't punished, bad behavior will continue unabated, and in fact, worsen to the point of systemic failure.  In the case of finance, this argument was applied most recently to Lehman Brothers during the financial crisis.  Hank Paulsen was worried that if the government bailed out Lehman, than it would send the message to the markets, no worries no foul, go ahead and invest poorly and mismanage your companies, because you've got a money back guarantee.  And of course, Paulsen let Lehman collapse, and the market dropped a thousand points overnight.  That in itself is an argument against moral hazard, but that's not where I'm going with this.

Here's the point.  The fear of moral hazard shows a fundamental lack of understanding about human motivations.  Humans not only repeatedly act against their own best interest, they are effected by both short term and long term interests in unpredictable ways.  Economists are particularly guilty of this, and this is why behavioral economics is becoming a big field.  So to draw a coralary here, the argument for capital punishment has always been:  It's a deterrent to the most heinous of crimes.  Well, dozens of studies over the years have proven that to be false.  There is no deterrent factor to the practice of capital punishment.  Likewise, the notion of certain corporate death ("CCD"), provides no fear for companies, or investors to change their habits. 

Why is that?  Companies aren't people.  Even the smallest company isn't a person.  While people may act to prevent their own death, there is no consistent rationality to demonstrate even that fact.  But even if you assume it's truth--and I don't--the fact is that companies never act like people.  The larger you are, the less of an identity you have.  AIG, for example, is composed of hundreds of small companies that were eaten by the larger fish, who kept three quarters of the staff, dumped the rest, claimed the assets for the parent's balance sheet and wrote off the liabilities as a restructuring charge.  Hundreds of different entities, all moving about on their own recognizance.  All loosely controlled by corporate management.  But even that doesn't hold true because, though company loyalty is a nice thing for managers, even managers routinely betray their company's best interests for temporarl payoffs that may or may not exist.  The runaway derivatives trading of the last decade is ample proof for that.  No one knew that George Bush, a Republican president, was going to issue the largest bank bailout in American history, the only reason the bailout was assumed was because we all knew deep down that letting everyone fail who deserved it would have been total death for the country, for the world.  Simply put, the argument for Moral Hazard relies on so many baseless assumptions that the only rational way to prove it would be to rely on statistical data, of which there isn't enough to come up with even a biased sample.

But even this isn't exactly the topic I wanted to rave about.  The guys at Planetmoney believe that if you guarantee companies, and risk moral hazard, you risk destabilizing the markets in an exceedingly critical way.  This would be true, if it were a risk.  I don't think it is, unpredictable risks aside.  And don't talk to me about Black Swans, because the financial crisis wasn't unpredictable.  Everyone and their blind, three legged hamster knew it was coming.

Listen: If I buy, again let's use everyone's favorite bully boy, AIG stock, I'm not buying it on the premise that the money is safe, but that I expect to make money on the return.  This is critical to my point.  The safest possible investment you can make, is in treasury stocks, so this can't be a matter of mere safety.  We're talking about returns.  So when I buy AIG stock, it might be nice to know it's backed by the government, but I'm buying it because I think it's undervalued and that it will reap a decent profit in terms of dividend, and in terms of rising stock price.  And that means, that I have to know something about AIG.  The Planetmoney men were concerned that the destablization would occur because the values would become essentially meaningless.  While that is a valid fear for entirely different reasons, like short-selling, I don't think there's any real fear of that for the overall market for stocks.  You have to know something about the company, you have to be making and upgrading your assessments of your positions.  And you have to do it fairly often.  And that means people making valuations--people struggling to name the price of an asset.  And that's what the market is--a place where prices are named and called.  To wit, a government backstop on corporate assets doesn't have the catastrophic effect on markets that media fear mongers would have us believe.