moral hazard and public policy

Harvard finance professor Josh Lerner is quoted today in the Austin American Statesman: “It’s sort of like, heads you win, tails the Fed picks up the pieces”. Professor Lerner made these comments in reference to the historically unprecedented and controversial Fed-engineered rescue of Bear Stearns (cf. “Bear Stearns fetches a better price, shoring up deal” to see this quote in its original context).

Clearly the motivation for the Fed to intervene in this fashion was to prevent a severe and pervasive “credit crunch” in the U.S. economy from going from bad to even worse. A couple of weeks ago, Bear Stearns suffered a classic “run-on-the-bank” scenario; its short-term creditors refused to lend the firm any more money via the extension of overnight loans, and simultaneously demanded repayment of outstanding debt. The net effect completely overwhelmed Bear’s cash position, which in turn forced the investment bank to seek help from JPMorgan Chase and the Fed. Since then, the Fed has opened its so-called “discount window” to investment banks as well as commercial banks. The last (and only other) time that this occurred was during the Great Depression.

From a risk management perspective, the decision by the Fed to take this action involves trading off the benefit of preventing a financial contagion in the short run against longer run moral hazard effects such as Professor Lerner has described. At this point in time, it is impossible to determine whether our economy will be better off as a result of this policy action. The most important asset that any organization, including the government, can have is the trust of its constituents. The problem with ad hoc regulatory interventions like this is that it raises the bar in terms of people’s expectations regarding future public policy; specifically, it encourages the notion that the government will bail you out if you are big enough and manage to mess up badly enough. Economists refer to this as “time-inconsistent” behavior on the part of government. The concern that many have about this action by the Fed is that it may make matters worse by effectively increasing systemic risk going forward. The issue here is whether the long run moral hazard consequences can be reigned in prospectively, or whether the action will effectively “up the ante” and encourage even more risk prone behavior on the part of investors, as suggested by Professor Lerner’s quote.