Home > Government intervention > Moral Hazard, another reason why the Bank Bailouts were a very very bad idea.

Moral Hazard, another reason why the Bank Bailouts were a very very bad idea.


Russ Roberts over at Cafe Hayek has a very good post on why the Bank Bailouts were a bad idea.

Over the past half century the financial industry has not treated the law as a bedrock institution that constrains the nature of its activities, but rather as a set of rules that can be forced to adapt to the industry’s needs and desires.  Thus, the industry knowingly and deliberately creates standardized contracts that are either designed to circumvent the law or in some cases flatly illegal under current interpretations of the law, and then when a case involving the contract arises (which in many instances happens only long after the standardized contract has become an institution), the financial industry tells the court that the dubious or illegal contract is so widespread that the court would create systemic risk by enforcing the law.  (This idea was established by Kenneth Kettering in “Securitization and its Discontents” and the next two paragraphs draw very heavily from Kettering’s article and perhaps form little more than an opinionated summary of several of his sections.) 

The post goes on to discuss how various financial “innovations” were illegal when put in place but were eventually condoned by the courts or the politicians in the name of avoiding systemic risk.

These are further examples of a process I discussed in my paper on the financial crisis. The bankers don’t sit around  (necessarily) figuring out how to rip us off but all the incentives are against prudence and favor their risk-taking. We, the taxpayers, end up paying for their mistakes.

Read Russ’ paper Gambling Other Peoples Money, if you already haven’t.

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  1. October 14, 2010 at 22:27

    Lower standards lead to bad results. 🙂

    One of my ‘theories of everything’ is that all problems can be traced to a bad feedback mechanism.

    Whether it’s grade inflation, encouraging bad loans, letting financial institutions and investors off the hook for their poor judgment, or admitting ill-prepared kids to college it’s all the same.

    In all these cases, properly functioning feedbacks were dissolved because folks viewed them as arbitrary and unjust. But it turns out they served a purpose.

    As Rupert Murdoch pointed out in the Wall Street Journal last week, American Idol has higher standards than education. Of course it does, government isn’t involved yet.

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