An Urban's Rural View

A few words about "moral hazard," a term as misleadingly named as it is frequently heard. Forget the "moral" part. Moral hazard has little to do with morality. It's the jargon of economists, not theologians or ethicists.

Moral hazard arises when X takes a risk but Y pays when things go wrong. It isn't that X schemes against Y. It's just that because X escapes the consequences, he is tempted to take more chances than he otherwise would.

As you might expect, insurers obsess about moral hazard the way Captain Ahab obsessed about the white whale. Will the man who insures his car against theft be more casual about locking doors? Will insured patients and their doctors be more apt to opt for unnecessary tests? Might a farmer with crop insurance take less fastidious care of his crop or plant on marginal ground?

"I wouldn't do those things," you might say. But some people might, so you can hardly blame the insurer for fretting about moral hazard.

Too-big-to-fail banks are moral hazard's contemporary Exhibit A. Uncle Sam can't let them go under; it would wreck the economy. So they're free to make dicey bets, confident they'll be bailed out if the bets go bad. They pay less to finance themselves because taxpayers relieve investors of some of the risk.

So morally hazardous are these behemoths that there are serious proposals to break them up.

Moral hazard is at the forefront of the crisis in Cyprus. The Germans and other northern Europeans were only willing to rescue the island's banking system if the solution imposed some pain and discouraged future risk taking.

The final deal: In exchange for a 10 billion euro loan to prop up the island's largest bank, the second largest goes poof. Insured deposits, up to 100,000 euro, are safe, but the bank's shareholders get wiped out.

Bondholders and uninsured depositors are wiped out, too, but they end up owning the bank's bad loans, for whatever can be collected on them. The good loans get taken over by the largest bank.

Markets were jittery when the Dutch finance minister suggested that this would be the template for future European bank restructurings. Understandably. It would shift risk from taxpayers to buyers of bonds in the big European banks. They would no longer benefit from moral hazard.

Cyprus faces tough times. Its status as a tax haven for rich Russians is history; having been burned, the Russians will no longer be coming. Runs on the remaining banks are possible; even if they don't happen, bank lending will shrivel and the economy will shrink. This may not be the last time the Europeans have to bail out Cyprus.

Whether Europe has really found a cure for moral hazard awaits a bigger test. It's one thing to demand such harsh medicine of an inconsequential island whose banks are small and the victims when they fail are Russians. It would be quite another to let banks fail in Italy or Spain.

The Germans hate moral hazard but they also want to hold the European Union together. It's doubtful they can do that without tolerating moral hazard somewhere.

(AG)

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