Tom Vanderwell on moral hazard

Paul Kedrosky has a guest post from Tom Vanderwell on moral hazard. Moral hazard describes a situation where parties behave differently because they do not expect to bear the full consequences of their actions. For example, when a guy in a bar acts especially belligerent because he’s got his big, tough friend with him, that’s moral hazard at work. Free market purists argue that moral hazard distorts the free market, and so firms and investors should not be insulated from risk. In other words, the FDIC should not exist, because then the risk of bank default would force customers to be more informed about the loans their banks make. This would cause banks who make risky loans to lose business, and thus strengthen the banking industry. Of course, there are reasons why we protect people from the consequences of risk, even if it... [read full story]