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Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy by Aaron Task, Barry Ritholtz

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Chapter 13. Moral Hazard: Why Bailouts Cause Future Problems

 

To be sure, some moral hazard, however slight, may have been created by the Federal Reserve's involvement. [Such negatives were outweighed by the risk of] serious distortions to market prices had Long-Term [Capital Management] been pushed suddenly into bankruptcy.

 
 --Alan Greenspan[94]

What is moral hazard? During this past year of our bailout, the phrase has been bandied about haphazardly. Let's define this important term before proceeding further.

Moral hazard is "the prospect that a party insulated from risk may behave differently from the way they would if they were otherwise fully exposed to that risk. It arises when an individual or institution does not bear the full consequences of its actions, and therefore tends to act less carefully than they otherwise would, leaving a third party to bear the responsibility for the consequences of those actions."[95]

That's the formal definition. E. S. Browning, writing in the Wall Street Journal, used this less complicated description:

Moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected.[96]

Hence, there is very real concern that the many bailouts of 2008 and 2009 are creating moral hazard, encouraging more reckless ...

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