Bailouts and moral hazards - are they linked?

James Surowiecki makes the case for financial bailouts and why bailouts may not bring the ticker of moral hazard attached...

Why might the effects of moral hazard be smaller than expected? To begin with, most bailouts aren’t like deposit insurance, which is certain and quick. Financial bailouts are uncertain and messy, and they typically occur only after institutions have already suffered extensive damage. Bear Stearns, for instance, was “saved” only after its shares had fallen almost ninety-five per cent from the previous year, and it seems unlikely that either its laid-off workers or its battered shareholders came out of the experience anxious to engage in more foolhardy behavior.

The moral-hazard argument also assumes that the most important factor shaping corporate decisions is the interest of the company as a whole. But, more often, what’s shaping those decisions is the interest of individuals, and on Wall Street those interests are often only loosely connected to the long-term health of companies. The fact that people can reap enormous rewards for decisions that are beneficial in the short term but costly in the long term is likely to lead to reckless behavior, regardless of whether companies are bailed out or not. Even if we allow Citigroup to fail, after all, Chuck Prince, the former C.E.O., will still have walked away with a package reportedly worth more than seventy million dollars.

Finally, the biggest reason that moral hazard matters less than it might is that it can operate only if people actively countenance the possibility that their decisions could lead to complete disaster. But it’s well documented that people generally, and investors particularly, are overconfident and significantly underestimate the chances of being wiped out. The moral-hazard fundamentalists argue that banks and other financial institutions will act recklessly if they think they’ll be rescued in the event of failure. But Wall Street was reckless because it never believed that failure was even a possibility.