October 4, 2008

WHY WOULD NIHILISTS CARE IF THE WHOLE BLOCK BURNS DOWN?:

Bailouts Are Inevitable, Even Desirable: Stop complaining about the "moral hazard" problem and enjoy the rescue. (Tim Harford, 10/03/08, Slate)

Moral hazard can sometimes take extreme forms. According to the St. Petersburg Times, in the late 1950s and early 1960s, more than two-thirds of insurance claims for the loss of a limb originated in the Florida Panhandle. At the epicenter, "Nub City"—the tiny town of Vernon, Fla.—almost 10 percent of the adult population had lost a limb. One man was said to be insured by dozens of companies when he lost his foot: Fortunately he had been carrying a tourniquet at the time of the accident. He pocketed $1 million. Another man shot his foot off—"while aiming at a squirrel"—just 12 hours after buying insurance. Now that's careless—and that's moral hazard in spades.

Sometimes moral hazard is so severe that it makes insurance impossible. Football players would like to insure against losing football games, and students would like to be compensated if their exams go poorly. Tough luck: Moral hazard makes such insurance contracts absurd. But all these examples exaggerate the problem. So does the archaic use of the word moral. It used to carry no ethical connotation, referring merely to a risk arising from human action rather than natural forces.

Forget the baggage that comes with the word moral. While moral hazard makes insurance more expensive and less efficient, many insurance markets work well enough to be useful. Moral hazard need not destroy them, and it need not destroy financial markets either. If AIG had shot off its own metaphorical foot to claim a government bailout, the argument against the bailout would be compelling. But it didn't, and it isn't.

This perspective can suggest lessons for today's bailouts. The government will not help you replace your possessions if you smoke in bed and your house burns down, but government-funded fire engines will put out the blaze, moral hazard or not. That is partly because fire can spread, and your neighbors should not suffer for your carelessness. The same motive lies behind the current spate of rescues. It is also because a civilized society tries to save people from accidentally burning themselves to death. If the consequence is a little more carelessness, so be it.

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Posted by Orrin Judd at October 4, 2008 7:49 AM
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