The Moral Hazard Story
Russ Roberts told it with great passion today. I’m hoping an audio will be available tomorrow. But he should not feel lonely. Simon Johnson and James Kwak write,
creditors had only limited incentives to watch over major banks. Ordinarily, creditors should demand high interest rates on loans to highly leveraged institutions. However, the expectation that large banks would not be allowed to fail made creditors more willing to lend to them. This is why the failure of Lehman was such a damaging blow: It shattered market expectations that the government would not let a major bank fail. The massive flight of money out of the banking system can be seen only as the result of an enormous shock. The next several months, up through the third bailout of Citigroup in February, can be seen as the government’s attempt to undo the damage by repeatedly saying “No more Lehmans” — which has made the implicit government guarantee stronger than ever before.
Kwak and Johnson are way more optimistic than I am about the ability to use regulation to overcome moral hazard. I call this the “too regulated to fail” approach, and I think it is self-defeating. What is needed, in my opinion, is a credible way to make lenders lose money when they lend to risky institutions. That means coming up with a definition of systemically important transactions that includes only everyday check clearing and ATM withdrawals, not credit default swaps and repo agreements.
I should note that John H. Cochrane and Luigi Zingales dispute the significance of the Lehman failure. They write,
the main risk indicators only took off after Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke’s TARP speeches to Congress on Sept. 23 and 24–not after the Lehman failure…
Why? In effect, these speeches amounted to “The financial system is about to collapse. We can’t tell you why. We need $700 billion. We can’t tell you what we’re going to do with it.” That’s a pretty good way to start a financial crisis.
As Russ points out, the media are now honoring Paulson, Bernanke, and Geithner for transferring hundreds of billions of dollars from ordinary Americans to some of the richest people on earth. And, if Cochrane and Zingales are correct, we are honoring them for putting out a fire that they started.