decision making, economics

Moral Hazard

Today’s blog post will be about moral hazard. It’s defined as:

a situation where a party does not bear the true costs associated with its actions, and therefore behaves differently than it would if it were fully exposed to the risk(s). 

We’ve been hearing the term more frequently lately in the news because of the “Great Recession’ our world economies just bore witness to. Narrowing down to the US, it was argued that through The Emergency Economic Stabilization Act of 2008,in which the government basically bailed out the US financial system by pumping upwards to $700 billion of liquidity into the system by buying distressed assets (that no one else wanted) and injecting capital into banks (so they could survive) was a prime example of moral hazard. Some argued, although it probably starved off a depression, that it wreaked of moral hazard because the risk takers that created the mess in the first place were essentially bailed out by the taxpayers and therefore not bearing the full cost of their actions. If the financial firms were allowed to fail, they would be bearing the full cost of their actions, but by bailing them out, they have further incentive to take on behaviour that could further threatened the financial stability of the financial system in the future, and therefore continuing the cycle.

Moral hazard also finds its way into our every day lives and how we interact with our friends and families. For example, if a friend comes to you for help in paying off his debt, and makes no promises to change his spending habits, and yet out of loyality you pay off the debt, you are living the moral hazard dilemma.

Another example, if you decide to drive on a stormy and snowy day because you have increased your insurance coverage, you are the moral hazard to the insurance company.

It’s easy to see that any one person could name hundreds of situations where there is moral hazard but without consciously thinking about it, we may not realize certain decisions or actions we make/take are made without regard to moral hazard. The outcomes of such decisions and actions may not have the intended consequences initially sought and may in fact outweigh the initial positive action many times over.

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