The Free Market 16, no. 12 (December 1998)
The phrase of the day is “moral hazard.” It’s something everyone seems to think is a bad thing, but few are willing to do anything about, certainly not Alan Greenspan. So far, he’s on record backing the Mexican bailout, the Asian bailout, the bailout of Long-Term Capital Management, and more IMF funding, despite the financial dangers all these create down the line.
Somehow, consistent with the mirages daily created by the Fed, Greenspan is still perceived as an old-school capitalist who wants the chips to fall where they may. In public appearances, he’s even explained and criticized the moral hazard inherent in bailouts, loose credit, and financial leniency in general. These practices appear to contain the harm caused by profligacy, excessive risk-taking, and unwise investment, when, in fact, as he has pointed out, they risk perpetuating those very behaviors.
The idea is simple. If you are continually willing to protect people from the consequences of their own errors, your benevolence will be factored into the future decisions of the persons rescued. In the long run, they will make even more errors. The principle exists at all levels. The teacher who changes grades when students plead hardship isn’t helping in the long run. The teacher is rewarding and thereby encouraging poor study habits. He is creating moral hazard.
So it is in banking and finance. How was it that the hedge fund Long-Term Capital Management, bailed out on pressure from the Fed, believed they could be leveraged 50-100 to 1 in some of the riskiest financial instruments in the world? True, the fund employed people who were said to be the smartest guys on Wall Street, plus two winners of the Nobel Prize in economics, and that gave the firm credibility the town-fair magician can’t get. True, also, that returns of 40 percent in 1995 and 1996 reinforced the appearance of superhuman intelligence.
More fundamentally, however, moral hazard was there from the very beginning. Credit has been generally loose in the mid and late nineties. The firm’s money was being loaned by banks backed by deposit insurance and an implicit too-big-to-fail doctrine on the Fed. The firm’s preferred investment targets (like Russian bonds) were backed by a bailout promise as well. The risk spiraled onwards and upwards until one day it unraveled, and the fund itself was bailed out.
One week after the bailout, Greenspan put his homilies on financial prudence on hold to defend his push for the bailout of Long-Term Capital. He said it was necessary to prevent the firm from being sold at a disruptive “fire sale.” If he had allowed that, it “would result in severe, widespread, and prolonged disruptions to financial market activity.” His intervention enhanced “the probability of an orderly private-sector adjustment.”
Spoken like a true believer in central planning. What he calls a “fire sale” was nothing more than the sale of a company at its true market price. As the Wall Street Journal revealed, the same day that the Fed pulled together a plunge team to kick in $3.5 billion, three other parties (AIG Insurance, Goldman Sachs, and Warren Buffett) made a collective offer of $250 million for the company, with an extra $3.75 billion kicked in to run the existing portfolio. However, they rightly insisted that the founder of the fund, the famed John Meriwether, had to be ousted.
Such is life under capitalism. Big profits can be had, but so can big losses. Long-Term’s assets had fallen from $4.8 billion in January 1998 to $600 million by late September. It is rightly assumed that anyone who invests in hedge funds (multi-millionaires, all) understands the risks. Long-Term Capital should have been thrilled there were buyers at all.
But while its managers liked playing the market, they apparently didn’t like the market playing them. So they rang up the Fed (a former vice chairman of the Fed is a partner), explained the stakes, and the Fed went to work overriding the reasonable market offer (the “fire sale,” as Greenspan says). The result was an infusion of funds 62 percent higher than the market offer. And John Meriwether got to keep his job.
Greenspan claimed that nothing less than the world economy was at stake. But it also happens that nearly every important banker in New York had lent money to Long-Term Capital, and they were all made vulnerable when sudden changes in the bond market wiped out the firm’s portfolio. The Fed’s institutional well-being is tied up with such banks, moral hazard or not.
Perhaps it shouldn’t surprise us that the Fed, not a market-created institution, would favor these kinds of public/private deals. But that doesn’t mean that they make economic sense. Actually, Greenspan’s metaphor of a “fire sale” is entirely apt. After a fire, burned and smoke-damaged objects should sell for their market, much-lower price. Consumers benefit and damaged goods are liquidated. If an outsider comes along to force the sale of burned objects at twice their market worth, it makes people just a shade less attentive to the demands of fire prevention.
(As an aside, free markets, unlike governments, are structured to reduce moral hazard to a bare minimum. Insurance companies that don’t take account of variables that affect the likelihood of accidents lose profits, unlike those who whittle down all variables to the random ones. That’s why insurance companies appear to be so snoopy, wanting to know about every speeding ticket and every cigarette smoked. They are in the business of assessing hazard and prosecuting fraud in cases where moral hazard exists.)
What’s going on here with Greenspan, who says one thing and does another? Murray Rothbard addressed this question when Greenspan first ascended to the throne. He pointed out that Greenspan is a long-time proponent of the gold standard, but only in theory. “In the real-world,” says Greenspan, “all the conditions have to be just right to have a gold standard. The budget has to be balanced, the government has to be small, and the banking system must be perfectly sound. So long as those conditions are not in place, we can’t have the gold standard.”
There’s an analogy here with Greenspan’s position on the moral hazard. In effect, he says, central bankers and government officials should never encourage it, losses should be born by the risk-taker, banks and hedge funds should be on their own, unless, of course, conditions are not ideal. The truth is that conditions are never ideal, and the Fed is part of the reason. But with his convenient mental categorizations, Greenspan is allowed to pursue disastrous policies while at the same time escaping blame for them.
So long as his policies appear to work, he can get away with it. But since actions have consequences, in the end, his legacy may yet be as the Fed chairman who was Mr. Moral Hazard.
