Conservatives are often accused of pushing their personal morality on others. Those on the left, particularly those who do not share the same moral values with social conservatives, claim that the “radical right” is attempting to use the force of law to enforce religious morality. Even many who are fiscal conservatives but social liberals (many of whom identify as Libertarians) level this claim. I have a few opinions concerning the matter, as one who tries to abide by a certain set of morals.
This post has nothing to do with any of that.
People respond to incentives. We talk of sticks and carrots when we want to set up a simply dichotomy amongst the means by which people can be motivated to do something they might not otherwise do. Sticks threaten some sort of discomfort for non-compliance, and carrots offer a reward for compliance. (Personally, I don’t find carrots to be very rewarding, even if they can be made into a delicious cake, but then I’m pretty sure the analogy comes from farm animals.)
The theory that people respond to incentives is based on the idea that people are trying to maximize their utility. (For those who aren’t econ junkies, “utility” in the economic sense is an abstract measure of happiness that can’t really be quantified, even if we talk about it as if it could be.) Essentially, people would rather be happy than sad, and they would rather be happier than less happy. Because of this, they will engage in behaviors that they believe to be the best route to getting more utility (again, pronounced happiness).
Utility is often spoken of in terms of positive and negative. Looking back to our barnyard example, the stick offers negative utility, and the carrot represents positive utility. (For a labor-related example, assuming such a situation were possible, the carrot would be “I will give you money if you work,” while the stick would be “I will beat you with a stick if you do not work.)”
In making a decision of whether to engage in activity or not, people will weigh (usually unconsciously based on thousands of heuristics that they have learned over the course of their lives) all of the factors that play into the decision. They very quickly calculate which of their options are going to make them the happiest, and then discard the other options. Inherent in such calculations is the idea of expected value.
Expected value is simply the sum of all possible outcomes, each having been multiplied by the probability that it would occur. (Sorry, a bit of math like stuff there, but it is kinda important.) Because probability of outcomes is part of the expected value, risk is part of the calculation.
Humans are, by nature, risk averse. For example, given the choice of walking over a deep ravine on a rickety bridge that may fall apart and send you to your death or walking on solid ground, most people would choose to walk on solid ground. If both get the same result in the best-case scenario but one has the worst-case scenario of death, while the other has the worst-case scenario equal to the best-case scenario, then the safer option is chosen. (There are always thrill seekers, but then the equation is changed, as they derive utility from the danger, which means there is a higher upside for success than in the safe situation.) While each person has a different tolerance for risk, we all would prefer less to more.
By now you may be wondering where I’m going. Risk is a stick, and a carrot. Classes are taught in risk management, because if we can somehow mitigate the risk, we can get the upside without having to suffer any consequences if the downside comes. This is what we call the moral hazard.
The moral hazard is a perversion of incentives. When a negative incentive is artificially eliminated, (i.e. the risk is eliminated), then the likelihood that people will engage in the activity increases. If I could get a money-back guarantee on Powerball (a multi-state lottery game with high payouts reaching into the hundreds of millions of dollars), then I would play every day until I won. There would be no downside and a potentially huge upside.
Obviously no one would ever give a money-back guarantee on Powerball. To do so would be tantamount to giving away money to anyone who bothered to ask for it. (Yes, you may have to ask repeatedly…) No one has that kind of money, not even those who pretend that they do.
Unfortunately there are some entities that were believed to have such a money-back guarantee. Fannie Mae and Freddie Mac were both believed to have the implicit guarantee of the federal government of the United States of America. Because of this, they were able to assume risks that others were not. They could issue mortgage-backed securities (essentially the right to purchase a small amount of the cash flow that would come from the mortgagee’s monthly payments) with less capital to back them up than a typical bank could under law.
This moral hazard had an interesting ripple effect. Because Fannie and Freddie were buying loans left and right, the risk that the banks took on when they loaned money could be offloaded onto F&F. (Think about the risk of buying a used car, and then think about buying a used car, knowing that you could sell it to your uncle, regardless of the condition, because he likes you, and he’s really rich, so he doesn’t care.) Since the risk to the banks who were issuing the loans was being assumed by F&F, they could loan money to people who they normally would have turned away. These higher risk individuals are those who were likely to default (stop paying) on their loans. Under normal circumstances the bank would not loan the money, precisely because the probability that they would get their money back would be too low.
Now that the risk was gone, banks could loan to those who fell in the category of “sub-prime.” The stick had been removed. Of course there was also a carrot involved. The federal government under the Clinton administration decided that it wanted more people to own homes. It began promoting “creativity” in financing in order to get more people into home ownership. While I don’t know the exact reason for this, I would surmise that the idea was that if people felt like they were well off because they “owned” their home, they would be more inclined to vote for the incumbent Democrats. Whatever the motive was, the result was that more and more people were pushed to try to get something they couldn’t afford.
At each step, there was an artificial removal of consequences. In the end, each consequence that was removed was only hidden. The risk of foreclosure because one could not afford his payments was simply forestalled, not eliminated. The risk of default to the banks was absorbed by Fannie Mae and Freddie Mac. Their risk was assumed to be covered by the federal government, which, in turn, figured it could simply borrow or tax its way out of anything. At each step, the buck was passed to the next level, and eventually the American taxpayers were stuck with the bill. (Well, bankers, too, with mortgage modifications, i.e. cram-downs)
While hindsight is said to be 20/20, the idea of the moral hazard is not even remotely new. The term is believed to be used as early as the 1600s. At each step, the organization that was insulating another from risk could have stopped and said, “Gee, what will this cause people to do?” Unfortunately, this was a case of wanting to cause people to do something and not paying enough attention to what the results would be. This was a case of social engineering, executed without fully analyzing the total costs. Frankly, I am reminded of F.A. Hayek, who said, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
As long as government is trying to shape society to be something other than it is, there are going to be unintended consequences of their actions. Understanding the source of the consequences we are currently experiencing (rather than simply blaming a previous administration) may help to figure out the right way to get our country back on the economic trajectory it once enjoyed. Whether one finds the fundamental social change sought by our current President is moral or not in the eyes of the polity, repeatedly inducing the moral hazard will continue to increase risky behavior, and I don’t think that will be good for the country in the long run.