The case for policy sustainability.

• Author: Munchau, Wolfgang

Should we worry about moral hazard while the house is burning? The discussion about economic policy is full of biblical metaphors, the language of water and floods, and of fire extinction during crises. Metaphors, even when not mixed, are often obstacles to the clarity of thought. That is clearly the case with the metaphor of moral hazard in trying to understand the current financial crisis. Instead of focusing on moral hazard, I prefer to use the concept of policy sustainability to argue that sustainable monetary, fiscal, and regulatory policies are essential for lasting prosperity.

Moral Hazard: A Bad Metaphor

Moral hazard is a metaphor, an expression derived from the economics of insurance. In that context, however, it has a precise meaning: it refers to a situation that arises when an insured agent acts irresponsibly to the detriment of others, as a direct result of being insured. The idea of moral hazard is certainly central to the economics of insurance, but the concept is not quite right when we try to describe the choice faced by financial regulators or monetary policymakers. Of course, we have heard hundreds of times the term "privatized gains and socialized losses," and it sounds both hazardous and immoral. But that catch phrase does not get us anywhere.

Moral hazard is a bad metaphor for this crisis because its precise meaning in the economics of insurance has no one-on-one correspondence to this situation. Of course, bankers behaved inappropriately. Who can deny this? But did they really all expect to get bailed out by their governments, in the way that an insurance fraudster expects to get compensated by his insurance? I do not believe that Bear Stearns executives ever thought it was possible that they had to crawl to the Fed one day for help. First of all, not all banks got bailed out. Lehman Brothers did not, nor did Wachovia. And second, moral hazard would imply that bank managers as a group should have acted in a conspiracy. Moral hazard would imply that they fully calculated the risks, and behaved accordingly. My impression was that they did not fully understand those risks, and followed the crowd. They certainly followed, and still follow, overoptimistic risk models.

Moral hazard does therefore not fully capture the problem, and it is best to discard this concept in this context altogether, and to apply the much more appropriate notion of policy sustainability. Moral hazard is of course unsustainable. If not counteracted...