On Friday, St. Louis Fed President William Poole gave a speech called "Market Bailouts and the Fed Put" (hat tip Calculated Risk). Poole discusses "whether Federal Reserve policy responses to financial market developments should be regarded as 'bailing out' market participants and creating moral hazard by doing so." Unsurprisingly, Poole thinks not.

How many investors today measure the value of a bond by the likelihood that it will continue to pay interest “under the acid test of depression”? How many investors today maintain portfolios robust against the possibility of inflation of the magnitude experienced in the 1970s or deflation of the magnitude experienced in the early 1930s? The answer, I believe, is “not many.”

The fact that few investors worry about extreme economic instability is a benefit of sound monetary policy and not a cost; changes in investor practice are conducive to higher productivity growth. The same is true for changes in household and firm behavior reflecting the greatly reduced risk of economic depression or even severe recession of the magnitude of 1981-82. If we did not believe that economic stability is good for the economy and for society, why would a stable price level and high employment be monetary policy goals? Just as a deductible changes behavior of insurance policyholders, so also does economic stability change investor behavior.

In other words, investors do take risks they would not have taken absent the "insurance" implicit the Fed's stabilization policy. But this is not moral hazard. Rather, it is precisely the point of the policy.

Note the sly rhetorical maneuver in Poole's last sentence, where he likens the change of behavior induced by the Fed interventions to those induced by an insurance policy deductible. A deductible, of course, encourages the insured to limit their risk-taking, to combat moral hazard, while Poole is claiming the Fed's behavior increases risk-taking, albeit in manner that he claims is beneficial and should not be called moral hazard. Likening the two makes Fed policy seem conservative or prudential, despite Poole's admission that its effect is to encourage risk taking.

Putting that aside, Poole is right to note that an increased level of risk-taking due to insurance does not in and of itself imply moral hazard. Insurance is crucial to an entrepreneurial economy precisely because operating a business often entails risks that are simply too great for the entrepreneur to bear alone. If there were no liability insurance, workers comp insurance, property insurance, etc., many small businesses would never come to be, and the best of those small businesses would never become engines of creation and growth that enrich us all. Insurance exists precisely to allow people to take risks they would not otherwise take. That is not moral hazard. It's the insurance business' core function, and not something insurers discourage at all.

Insurers call behavior "moral hazard" not when people take on risks that they otherwise would not have taken, but when they take on risks greater than those that were priced into their policy. A well-designed insurance policy does not permit an entrepreneur to escape the costs of their risk-taking. It simply alters the distribution of those costs: Instead of experiencing rare but catastrophically large costs, the insured bears the full expected cost of her behavior, but in the form of regular, predictable payments. Ideally, insurance puts a price on risk, and internalizes the cost of risk-taking, so that actors can rationally choose which risks are worth taking, and which are not.

To the degree what the Fed does is offer insurance to firms and investors, it is inherently creating moral hazard, because those actors are not paying an appropriate premium for the insurance. Homo economicus, when insured at a premium that bears no relationship his behavior, will maximize risk-taking, since the cost of risks gone bad will be borne by others, while the take from gambles that succeed will be his to keep. Among the fully insured, prudence is idiocy. In a competitive environment, the prudent will simply fail to survive. Eventually, the aggregate costs of other people's bad risks become too large for the insurer to bear, and then no one survives. Overinsuring private risk creates systemic risk.

Now Poole claims that this kind of thing is not happening, that whatever it is the Fed does, it does not bail out those who take on bad risks:

Federal Reserve policy that yields greater stability has not and will not protect from loss those who invest in failed strategies, financial or otherwise. Investors and entrepreneurs have as much incentive as they ever had to manage risk appropriately. What they do not have to deal with is macroeconomic risk of the magnitude experienced all too often in the past.

Obviously, Poole is right at a certain level. Firms and investors lose money every day. The Fed does not sit behind each and every actor in economy, absorbing every loss while smiling on private gains. But no critic of the Fed has ever suggested any such thing. The Fed's propensity to intervene in a crisis reduces the private costs of certain kinds of risk-taking, but does not eliminate those costs. To continue with an insurance analogy, the Fed is like an insurer that collects no premiums, but unpredictably pays out only 20% of all claims. To risk-averse actors, that's like no insurance at all. But to financially strong, risk-neutral (or leveraged, risk-loving) investors, the "Fed put" reduces the average cost of failure substantially. This leads to a broad underpricing of risk, or an overpricing of assets.

"Overpriced assets" sounds anodyne, even benign. That's wrong. When assets are overpriced, real resources are destroyed. Real people sacrifice real goods and services to some enterprise that is likely to produce less than the value of the goods and services originally sacrificed. If monetary policy shifts so that the investors come out whole in financial terms, that doesn't alter the fact of real economic destruction. It simply socializes the costs. Monetary policy and microeconomic outcomes sit far from one another, and the trail of tears evaporates quickly. Perhaps, as Alan Greenspan suggests, we owe the new home development ghost-towns appearing across the country to a post-Cold-War peace dividend. But I think the Fed, and, more broadly, the broken US financial sector had a great deal to do with the tremendous misallocation of real resources that was the late housing boom.

It's common and easy to criticize the Fed. When histories are written about the hard times ahead, I don't think the Fed will be the central villain of the piece. There are so many deep flaws in the American and global financial system, so many absurd institutions, shortsighted, foolish, and corrupt players, I think the Fed is more likely to be viewed as inept cheerleader than central protagonist. But Poole's speech is a defense of cheerleading.

It is the job of financial markets to price alternative uses for scarce resources, which is almost entirely about pricing risk. But in the short run, it is always tempting to hide risk, rather than to price it. When financial alchemists tout diversification and securitization as magic bullets, they are hiding risk rather than pricing it. When, as Poole notes, the wizards of the 1980s sold "portfolio insurance" prior to the 1987 crash, they were hiding risk rather than pricing it. When loan "originators" rely upon FICO scores and stated income to produce assets they quickly flip, they are hiding risk rather than pricing it. When the Fed intervenes to stabilize the US financial system despite Wall Street's increasingly poor stewardship of the nation's real economy, it is hiding risk rather than allowing risk to be priced. Unpleasant events in financial markets aren't to be tolerated because they "punish speculators", but because financial markets must accurately reflect the state of the real economy in order to allocate resources properly. The longer risk is hidden, rather than priced, the greater the pain when the consequences of poor choices can no longer be ignored. We will have to face that pain eventually, despite the fact that it is least well-off who will bear the brunt of it, rather than the bankers, traders, and dealmakers who got us here. Hopefully the hard times will be short, and we will have a chance to do better next time.

Update: For a more enthusiastic reading of Poole's remarks, try Mark Thoma. Also, Stephen Cecchetti has published an essay which, while not referring to Poole's speech directly, makes almost precisely the same points. An earlier essay by Cecchetti in favor of contract standardization and clearinghouse-based trading (frequently highlighted by Yves Smith) was wonderful. But on the question of central banks and "moral hazard", I can't quite agree with either of these good professors.

Update History:
Steve Randy Waldman — Sunday December 2, 2007 at 7:38am permalink
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