When I used to teach moral hazard to my students, I used the following example:
Suppose you want to get rich. Here’s how:
1. Borrow $30 million from Bill Gates.
2. Go to Vegas, put $1 million on each number from 1 to 30 on the roulette wheel.
3. If you win, most casinos will pay out $35 million or $36 million. Pay back Gates, and pocket your profit of $5 million or $6 million.
There’s a 30/38 chance you will win, which is pretty good. (Otherwise, default on the loan.)
In my view, this sort of “moral hazard” is basically the cause of the banking crises of the 1980s and 2007-12. Banks got aggressive with depositor money, knowing that FDIC would be on the hook for a part of any loses.
Moral hazard also seems like one way to make sense out of the seemingly random series of moves taken by President Trump. Consider:
1. Trump seems to pursue high risk negotiating tactics on everything from Iran to North Korea to Putin to international trade wars. It’s hard to find any common thread here, other than risk taking. Note that his Iran policy is quite hawkish, and his Korea policy is dovish. Suppose Trump is trying to maximize the chance that he can obtain some sort of bold breakthrough. It might pay to be a bit reckless. Yes, there’s a small chance of some sort of catastrophic outcome, but the cost of that would be widely shared. If the daredevil tactics achieve a breakthrough, he can take personal credit. Importantly, Trump has arranged things so that the GOP more broadly would not share in that success. This sort of risky approach would be difficult to pull off in a European-style parliamentary system.
2. Trump recently recommended that the Fed refrain from raising rates. That’s the sort of policy that would help the economy in the short run, at the cost of increasing the risk of recession after the next election.
3. Trump favors a wildly expansionary fiscal policy. The administration just raised the forecast of the 2019 fiscal deficit by roughly another $100 billion, up to nearly $1.1 trillion. To put that number into perspective, just a few years ago the deficit was $500 billion. And deficits are supposed to fall when the unemployment rate falls to very low levels. Even under Reagan, the budget deficit fell substantially as the economy recovered. Trump’s fiscal policy can be seen as a program to make the economy look good right now, at the cost of higher taxes and slower growth for future generations. A sugar rush.
Also keep in mind that if Trump actually wanted to reduce the trade deficit he’d call for fiscal austerity, not stimulus.
4. Trump favors weaker financial regulation, which will boost growth in the short run at the cost of an increased risk of financial calamity down the road. Actually, there are good arguments for financial deregulation, but it needs to be combined with a reduction in moral hazard. Trump doesn’t favor that.
5. Trump doesn’t want to do anything about global warming, which adversely affects later generations.
6. Trump is trying to reduce immigration of highly skilled workers, a policy shift that will cause the economy to slow very gradually over time. The big costs occur later.
Perhaps I am missing some important administration initiatives. Which of his policies call for sacrifices that would make Trump less popular today, in order to achieve important gains for future generations?
PS. Yes, this sort of thing is always a problem with American presidents, but has it ever been quite this extreme?
READER COMMENTS
Maniel
Jul 22 2018 at 8:34pm
Prof. Sumner,
In your opinion, what are the potential short-term payoffs of trade and immigration restrictions?
Scott Sumner
Jul 22 2018 at 11:37pm
Maniel, I don’t see any positive short term payoffs in economic terms. Perhaps there is a short run political payoff.
Michael Byrnes
Jul 24 2018 at 6:47am
There is, if you were to take the view that most people don’t care that much about free trade and won’t connect rising prices of certain consumer goods to Trump’s restrictions on free trade.
Maybe Trump opposes it because it plays well with his base, and the left supports free trade because of Trump’s opposition to it.
James
Jul 23 2018 at 8:15am
Not doing anything about global warming makes Trump unpopular today, at least among those who believe doing something about global warming is a good idea. Maybe all of those people already hate him for other reasons besides global warming.
A separate issue is whether future generations will be harmed more by global warming or by the policies proposed as a response to global warming. Most of these policies involve some sort of taxes or other costs being imposed upon businesses. It is reasonable to believe that these costs will lead to lower rates of economic growth for years and compounded over the horizons used in discussions of global warming, the welfare impact to future generations could be very large even net of any improvement in temperatures.
njhoepner
Jul 23 2018 at 1:28pm
Not doing anything about global warming is VERY popular with: a) Trump’s base; b) the fossil fuels industry; and c) portions of the Evangelical community who believe either ‘it’s all going to burn anyway, and soon’ or ‘God will magically protect us from the consequences.’ There is overlap between all these groups. So no real political risk to Trump in this regard.
As for the long-term consequences, that depends very much on what the costs of global warming will be, both in terms of economics and in terms of basic well-being and even survival. As long as economic growth stays ahead of population growth, slowing it down (assuming policies to combat global warming really WOULD slow it down, which is debatable) is not catastrophic. The consequences of global warming, especially combined with other forms of environmental destruction (which we don’t think about as much as we should), very well could be. We can see it in “laboratory” examples already – the Aral Sea, the Salton Sea.
Given the long-term consequences each way, environmental protection (including combating global warming) is smart long-term policy. Environmental apathy is at the very least imprudent, and if one considers what it could do to our grandchildren and beyond, morally questionable.
Weir
Jul 23 2018 at 6:06pm
Pretending to do something about global warming is a distraction from actually protecting the environment.
All the time wasted on one subject is time that could have been spent on a different, more urgent subject. For example, all the deaths being caused right now by smoke inhalation when people in poor countries burn wood or dung to heat their homes. For another example, all the plastic being dumped into the Indus, the Yangtze, the Mekong and the Nile.
Weir
Jul 23 2018 at 6:04pm
The politicians say these costs are imposed on businesses, but when people are forced to pay higher prices for less reliable electricity, that’s who pays.
People can try to reduce their electricity bill by leaving the air con off in summer, or not turning the heating on in winter. There are old people who don’t make it through a heat wave because they were worried about the cost of switching the air con on. And in a cold snap, the statistics for old people are even worse.
So the politicians talk about saving the planet for coming generations at the same time that old people are paying the price right now for artificially expensive electricity bills.
IVV
Jul 24 2018 at 4:11pm
Incidentally, this is why I rankle when Europeans (and Northern Europeans especially) chastise the United States for their widespread use of air conditioning. Not only is cold weather more generally fatal than hot weather, but the answer to cold weather is classically burning things for warmth (whether through radiators, or fireplaces, or centrally generating steam, or whatever system you use, in the end, you’re burning fuel). That generates far more emissions than air conditioning, which can rely more on solar power anyway.
Really, we all should be moving to warmer climates and relying on low-emission climate control solutions for comfort.
Thaomas
Jul 23 2018 at 8:58am
I think you have the moral hazard of the financial crisis wrong. Banks were not relying on FDIC, they were relying on the government to protect the shareholders as they largely did by not zeroing out shareholders of bailed out institutions.
EB
Jul 23 2018 at 9:28am
In relation to your example of moral hazard, either you failed to explain the example correctly or you don’t know what moral hazard is. Bill Gates had never lent money without knowing the risks the borrower was going to take: only if there was some way in which after the signing the contract the borrower could increase the risk to be taken without paying a price for it, then you could say that there was moral hazard (read Bolton&Dewatripont, Contract Theory, or just the definition of moral hazard in Wikipedia).
In principle, none of the Trump’s actions you have listed involve moral hazard. Yes, they are risky as most of our actions are. More important, in comparison with the actions of past presidents, each of the actions you listed implies a small risk. The only exception may be the first point you make, the one that Trump inherited from Obama and past presidents that did everything to put the U.S. at risk of war with Iran, North Korea and other countries.
Scott Sumner
Jul 23 2018 at 10:16am
Thaomas, Unless I’m mistaken, only a tiny fraction of failed institutions had their shareholders bailed out. FDIC was a far bigger problem.
EB, Obviously I understand that Gates would be unlikely to lend me $30 million. My point was that if he did, there would be moral hazard.
Read Today’s FT piece on how Trump thinks he’s playing with “house money”.
EB
Jul 23 2018 at 11:24am
That’s not moral hazard. If Gates lent you any money knowing that you will not repay him, Gates would be an idiot. And I bet you he’s not.
EB
Jul 23 2018 at 11:49am
Regarding the FT, again it has nothing to do with moral hazard. In the interview, Trump used the expression “We are playing the bank’s money, right?” to mean that it was a good time for him to renegotiate agreements. Yes, there are good and bad times to renegotiate agreements and he is right that this is a good time to do it –regardless of my opinion that it’s a waste of time to renegotiate agreements that are ambiguous and poorly enforced (he should be doing what the Chinese and other governments do, that is, to take advantage of those deficiencies).
EB
Jul 23 2018 at 11:56am
In government, the equivalent of moral hazard may be the abuse of power with the expectation of total impunity. It’s also called corruption.
Scott Sumner
Jul 23 2018 at 2:28pm
EB, I’m not sure you know what moral hazard is.
And I did not say Gates would know that his loan would not be repaid—most likely it would be repaid.
EB
Jul 23 2018 at 3:22pm
From Wikipedia, you can get the simplest definition
“A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.”
For a much longer analysis go to Bolton & Dewatripont, Contract Theory, p. 20 (but you have to read all the Introduction to understand exactly what they mean).
The key word in Wikipedia’s definition is AFTER. That was the original meaning in insurance contracts because after signing the contract the insured would have incentives to increase their exposure to risks (of course, the insurance companies learned long ago how to deal with it by writing proper fine print on insurance policies). When governments act as insurers, they don’t pay attention to moral hazard (I don’t have the book with me now but if I remember correctly you can read a discussion in David Moss, When All Else Fails – Government as the Ultimate Risk Manager, 2004; you can also review the literature on central banks as lenders of last resort and why they are not last).
As all technical words, the popular use soon may lead to misuse but this a blog on economics.
Max More
Jul 23 2018 at 8:54pm
Not that it’s due to any smartness or knowledge on Trump’s part, but his refusal to go along with the ludicrous policies to combating global warming — at vast expense and minimal effect — is excellent and right and a terrible example of moral hazard. Even if you accept that humans are primarily responsible for global warming, the suggested means of fighting it (rather than adapting) are insanely ineffective AND expensive. In addition, at LEAST the first couple of degrees C warming would have net positive effects. It’s also amusing to note that the USA stands out from all of Europe in reducing its CO2 output in recent years.
EB
Jul 23 2018 at 9:41pm
Your point reminds me that any of the policy ideas mentioned by Scott (except for the first one that is a grotesque caricature of what has happened in the past 30 years) has been discussed for many years and still there is no agreement on the benefits and costs of proposals related to them. We, economists, have agreed long ago (in the 1950s) that proposals should be assessed by their expected benefits and costs and that it is a waste of time to discuss general ideas about what could be good while ignoring their costs or what could be bad while ignoring their benefits.
Scott Sumner
Jul 24 2018 at 1:06am
EB, That definition seems incomplete, it leaves out motivation.
EB
Jul 24 2018 at 2:40pm
Econ 101: Why change after signing a financial contract? Because apparently, the other party left on the table a good 100-dollar bill.
If you need a longer reply read the entry in Wikipedia.
BW
Jul 24 2018 at 4:16am
4. Trump favors weaker financial regulation, which will boost growth in the short run at the cost of an increased risk of financial calamity down the road. Actually, there are good arguments for financial deregulation, but it needs to be combined with a reduction in moral hazard. Trump doesn’t favor that.
Prof. Summer, how could an administration actively reduce moral hazard? I thought one of the problems with moral hazard is the difficulty of signalling to current investors that a future government will not bail them out if they behave recklessly.
For example, imagine that the behavior of the current financial markets has a risk level of X, but if current investors believed that a future government will not bail them out, then they would reduce their risk level to Y, where Y < X. The problem is that determining Y is a counterfactual exercise and so it is inherently difficult. This counterfactual problem means that we can’t just point out who is behaving recklessly and tell them to stop, because we don’t know who they are. A hypothetical President Smith could loudly declare that he will not bail out any failing companies, no matter how big they are. But even if Wall Street believes him, it may determine, maybe even correctly, that there is little need to reduce its risk level to Y because a recession is not likely to occur while Smith is president. President Smith and his Congress could attempt structural changes, but any legislation forbidding Congress from giving bailouts could be overturned by a future act of Congress. Maybe the optics of overturning such legislation would deter a future Congress; or maybe, if the crisis is bad enough, a future Congress could spin its actions as necessary to save the economy. (Remember George W. Bush: “I’ve abandoned free market principles to save the free market system.”) Short of a constitutional amendment, it is hard to imagine which structural reforms could prevent a determined, reckless Congress. And because of the counterfactual problem, we will have a hard time determining whether any of the moves made by President Smith have had the desired effect.
Thus, it would seem that the only way to confidently reduce moral hazard would be for a company that is perceived as being “too big to fail” to fail, and then for the administration at the time to refuse to bail the company out. This could quickly update Wall Street to the new reality. But this would be a passive strategy, requiring the government to wait for the next crisis, rather than fixing the moral hazard now and preventing the next crisis. But maybe I’m just not being creative enough. Is there a way to actively fix moral hazard?
Michael Byrnes
Jul 24 2018 at 6:52am
I think the principal ways a government could reduce moral hazard is through legislation that 1) ends the tax-advantaged treatment of debt, and 2) imposes strict capital requirements (that is, finance via equity, not high levels of cash reserves) on banks.
Scott Sumner
Jul 24 2018 at 12:28pm
BW, Good question. The best way would be to reform FDIC. Require insured deposits to be backed with safe assets such as T-bonds. Higher capital accounts also reduce moral hazard as Michael pointed out.
Importantly, neither political party wants to do this. Moral hazard is a feature, not a bug, in their view.
You are right that it’s hard to commit to no bailouts, but we have other very powerful tools that we simply do not want to use.
EB
Jul 24 2018 at 2:57pm
You believe the government can be constrained magically by the Constitution and the laws. Obama and all past presidents proved that a President can abuse power with impunity any time. As I said in an earlier comment that is called corruption. It doesn’t matter what a financial regulation says, what it matters is how it’s applied and enforced. But we know –because recently we were reminded by Obama many times– how corrupt a president could be in applying and enforcing laws and regulations (in particular when the president doesn’t get the Constitution, the laws and the regulations that he wants).
Please read Robert Higgs, starting with
http://blog.independent.org/2018/02/13/roving-bandit-stationary-bandit-and-income-tax/
EB
Jul 24 2018 at 3:50pm
Scott, if you read the new WSJ editorial on the FISA warrants against Carter Page, you will understand how a president –using sicarios paid by you and all taxpayers–can abuse power with impunity. It’s not moral hazard. It’s corruption.
Ada
Jul 25 2018 at 3:23am
Question for Scott:
Can interest rates be used to offset this kind of risk? And if so what do you think would be the political counterpart to interest? (Interesting article btw, thanks!)
robc
Jul 25 2018 at 10:18am
Betsy Devos?
If she leads to the destruction of the DoEd, that would be a huge gain for future generations.
Scott Sumner
Jul 25 2018 at 11:48am
Ada, I don’t see how interest rates would offset the risk.
robc, Trump has no plans to abolish the DOE. But I agree it would be a huge plus if he did.
robc
Jul 25 2018 at 2:25pm
Scott, are you sure? I am a big believer in revealed preferences over stated preferences and he did appoint DeVos. If that isn’t a revealed preference towards abolishing it, its a move in that direction.
I am not pro-Trump, but I think most of the worst of the anti-Trumpers pay way too much attention to what he says and tweets and not enough to what he does.
He is in no way a stealth libertarian, but he isn’t when his enemies say about him either.
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