Tuesday, 12 June 2012

Governments' Moral Hazard.

“Too big to fail” and “moral hazard” are not new concepts at all, although many politicians and regulators seem to have discovered or re-discovered them in recent times. Since the firsts bank bail-outs occurred during the onset of the global financial crisis in 2007 and 2008, governments and regulators have been working very hard to find a solution to the “too big to fail” and the “moral hazard” dilemma in order to protect taxpayers’ money from any future bail-outs. However, I wonder, should we not be looking at “too big to fail” governments instead and the “moral hazard” created by bailing-out governments?

In relation to banking, the “too big to fail” problem is essentially the conundrum that if a large bank fails, the ripple effects it will have in the economy will be much worse than the costs of rescuing it and therefore taxpayers, instead of shareholders and bondholders, end up picking up the bill of broken institutions. Consequently, if banks or other financial institutions know that they will be rescued instead of let fall, “moral hazard” emerges, and sometimes becomes entrenched in the system, because these institutions will be willing to take on greater risks under the comfort that if the situation turns for the worst they will be bailed-out by   governments (taxpayers).

Because of those nasty consequences, politicians and regulators of most developed countries are looking into possible solutions which minimise the cost for taxpayers. So far, some of the ideas put on the table are good intentioned and not so far from a basic capitalist’s principle commanding that broken, unsuccessful, companies should be allowed to fail and that owners, and not unconnected third parties,   should carry the burden and the costs of such failure. However rules produced by politicians and regulators are intrinsically flawed and the current proposal are becoming, as usual, a lobbying and a political fight. It would have been a better idea to allow the market to come up with its own solutions, but that is a separate point.

In terms of specific techniques currently being implemented, for example, in the US the Dodd-Frank Act in effect creates a two tier system: financial institutions categorised as “too big to fail” and therefore forced to fail in a coordinated manner, including, for example, the regulator forcing bail-ins (creditors becoming shareholders) and other financial institutions which do not pass the filter and therefore will be allowed to fail. On this side of the pond, the Independent Commission on Banking has produced the Vicker’s report suggesting that retail operations of banks should be ring-fenced from the more exotic investment banks activities, especially proprietary trading, in order to avoid damaging spills on depositors and the more traditional lending business. In parallel, proposals are also being formulated to create “living wills” in order to allow for the orderly dismantling and failure of trouble banks. Some even argue that banks should be forcibly split up and reduced in size altogether. 

However, it is hypocritical and shocking, that some politicians are so keen on making rules and new legislation related to the financial system but forget to look at themselves in the mirror. How can these politicians blame banks for taking risks under the safety of the taxpayers net when their own politically driven bets are made directly using taxpayers’ money? Why is it so benevolent and altruist to do so in the latter example but morally repugnant in the former? Taking into account that these politicians are proposing measures against banks’ bail-outs while, at the same time, supporting government bail-outs, the inconsistency is even more painful. We do not need to look further than the recent Spanish’s banks bail-out to see an example of this inconsistency.

Although it is true that sometimes banks’ behaviours can be riskier than usual based on the security net provided by governments bail outs, any losses are most of the time borne by private investors. When the private sector takes risks this is always done using private funds. On the other hand, any governmental action, for good or for bad, is always backed by taxpayers money. Governments are the uttermost   example of “moral hazard”. Furthermore, in today’s world, states have become so huge and interconnected that their failure will create devastating flows destroying domestic and international economies. Even relatively small states such as Greece are a risk for the entire world economy. For that reason, millions of pounds have already been poured into Greece, Portugal, Ireland and Spain, effectively creating the same “too big to fail” and “moral hazard” conundrum but this time at the sovereign level. Taxpayers from Euro-zone countries and taxpayers from other countries (through the IMF) have shouldered the rescue of these governments who got ran out of cash after spending it lavishly.

Therefore, as with the private sector, we need similar free market measures for governments. Bail-outs must stop and sovereign states must be allowed to fail and default. Creditors, and not taxpayers, should carry the burden. And most importantly, real actions need to be taken to limit the size and interconnectedness of governments as well as ensuring that precise techniques are designed to avoid “moral hazard” and taxpayers’   money being used to perpetuate “zombie” countries. For a start, cutting taxes will be a good beginning since less tax revenue means less to spend and therefore it is the best possible limit to the size of governments. Also, taxpayers need to realise how morally   repugnant the “moral hazard” heralded by governments is and they should demand tighter controls in the way governments spend their money.

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