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What Causes Moral Hazard?

Jörg Guido Hülsmann
September 7th, 2018
Mises Institute
Comments (16)
Read by 1,116 people

This article was originally published by Jörg Guido Hülsmann at Mises Institute

A central occupation of economists is to analyze the nature, causes, and effects of incentives—the circumstances that are held to motivate human action. Economists agree on the positive role that “good” incentives play to increase production. They also agree that “perverse” incentives have an opposite impact. One of these perverse incentives is called moral hazard.

Moral hazard is the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes he knows, that someone else B will provide some or all of these resources. The important point is that this occurs against B’s will and that B is unable to sanction this expropriation immediately. The mere incentive to rely on resources provided by others is not per se problematic.

For example, the announcement of a future inheritance might prompt the prospective heir to spend more in the present than he would otherwise have spent. In such cases we would not speak of moral hazard. A genuine moral-hazard problem appears however if A has the possibility to use B’s resources against B’s will and if he knows this. Laymen would call A’s incentives a “temptation to steal” or a “temptation to act irresponsibly.” Economists, ever weary of moralizing, have espoused the technocratic expression “moral hazard.”

The essential feature of moral hazard is that it incites some A-people to expropriate other B-people. The B-people in turn, if they realize the presence of such a moral hazard, have an incentive to react against this possible expropriation. They make other choices than those that they would consider to be best if there were no moral hazard.

Many economists have therefore concluded that moral hazard entails market failures; it brings about a different allocation of resources than the one that would exist in the absence of moral hazard. Conventional economic theory explains moral hazard as a consequence of the fact that market participants are unequally well informed about economic reality. In other words, moral hazard results from “asymmetries of information” and the theory of moral hazard is therefore considered to be a part of the economics of information.

That people act on the basis of different knowledge about the real world will hardly be contested. The baker knows other things than the astronaut, the opera singer other things than the teacher of mathematics. Neither can it be doubted that people are unequally well informed about the real world. Some bakers know more about cakes, cake making, and the cake market than others, and so on. In short, information asymmetries are a universal aspect of human life as we know it. They are both a cause and a result of the division of labor. There is no reason to suppose that they are a priori harmful or a sign of imperfection. Conventional theory therefore stresses an additional condition to explain the emergence of moral hazard, namely, the separation of ownership and control. Two main cases can be distinguished: co-ownership and agency contracts.

In the case of co-ownership, any one owner has control over a given piece of property, but not exclusive control. Informational asymmetries can then produce moral hazard in conjunction with this separation of ownership and control. Whenever one co-owner of a swimming pool cannot effectively monitor the activities of his fellow-owners, the latter have an incentive to swim without cleaning up, repairing the fences and so on, thus increasing their own (monetary and psychic) income at his expense.

Similarly, in the case of an agency contract, moral hazard can arise when an economic good is not effectively controlled by its owner (the “principal”) but by a different person called the “agent,” for example, by an employee. Again, informational asymmetries produce moral hazard in conjunction with this separation of ownership and control. The agent, who is fully informed about his own activities, has an incentive to act in his own material interest against the material interests of his less informed principal. Whenever the principal cannot effectively monitor the activities of his agent, therefore, the latter has an incentive to increase his own (monetary and psychic) income at the expense of the former.

The standard case of moral hazard in an agency setting is an insurance contract. Here the insurance company is the less informed principal and the insured person is the agent. Automobile insurance, for example, creates a moral hazard for drivers; it creates an additional incentive for risky driving because other people (other clients of the insurance company) will pay a part of the costs of the agent’s accidents.

Similarly, in the presence of unemployment insurance, an unemployed person has an additional incentive to stay unemployed because other people will pay at least a part of his living expenses. Or, in the presence of health insurance, insured people will have an additional incentive to engage in risky activities or lifestyles because others will pay at least a part of the treatment in case of illness or accidents.

However, moral hazard is in no way a particular problem of the insurance industry. It can arise in almost any other field of human activity where there is a separation of ownership and control. Employees can be subject to moral hazard to the extent that they can reduce their efforts without fearing reduced pay. Debtors may be subject to moral hazard if they believe they can squander the money without negative consequences when they turn out to be incapable of paying back. Certain auditing firms have been subject to moral hazard when they sold consulting services to the very companies they were supposed to audit (for example, in the Enron case).

A central bank can produce moral hazard in the banking community if the commercial bankers perceive the central bank as a lender of last resort. The IMF can produce moral hazard among debtor governments. Taxpayers are said to be subject to moral hazard if they can evade high-tax regions, and so on. Similarly, in the literature on public choice and constitutional political economy, governments and parliaments are often portrayed as agents prone to moral hazard, whereas the voters are the less informed principals.

Important though moral hazard stemming from a deficient definition of property rights might be in practice, it is no match for moral hazard that results from a forced separation of ownership and control.

By a “forced” separation of ownership and control we mean a separation brought about against the will of its owner. Although owners might be forced both by governments and by private parties, government interventionism is far more important in practice. This is so not only because of the greater quantitative impact, but also because, in our western societies at least, interventionism is usually enshrined in the law and thus can be anticipated.

Government interventionism must not be confused with a mixed economy. In the latter the government is one of several owners and it controls only its own property. By contrast, an interventionist government commands other property owners to use their resources in a different way than these owners themselves would have used them. In so doing, the interventionist government makes some person or group A (for example itself) the uninvited co-owner of other agent B’s property. The essence of interventionism is precisely this: institutionalized uninvited co-ownership.

Government makes itself the uninvited and unwanted co-owner whenever it taxes, regulates, and prohibits. The specific forms of taxation, regulation, and prohibition are myriad. The important fact is that any form of government interventionism, by its very nature, entails a forced separation of ownership and effective control.

Taxation means that the government proclaims itself the owner of (a certain share of) resources belonging to its subjects; and that it forces them to eventually hand over these resources, which the latter would not have yielded voluntarily (otherwise one would not speak of taxation, but of donations to the government). Today taxation does not concern concrete physical items, but their monetary equivalent. It follows that, until the tax is paid, the government imposes itself as the co-owner of virtually all physical assets of the taxpayers. However, until the tax is paid, the resources in question are typically controlled by the citizen.

Regulation means that the government proscribes a certain use of certain resources. This use is typically not the one that the citizens would have chosen (otherwise the regulation would be pointless). Again, the government thereby proclaims itself the co-owner of these resources. Consider the case of price controls. If the government fixes a minimum wage rate, it effectively proclaims itself the co-owner of workers, because it does not allow them to work under conditions they see fit. And it also proclaims itself the co-owner of the capitalists or, more precisely, of the money that the latter plan to spend on labor. However, the government does not permanently control the actions of the workers, and it does not interfere with other uses of the capitalists’ money.

Prohibition means that the government outlaws a certain use of certain resources altogether. Again, it thereby proclaims itself the co-owner of all resources that could be put to the prohibited use. For example, if it prohibits the production and sale of alcoholic beverages it effectively imposes itself as a co-owner of all resources that could be used for the production and sale of such drinks. However, it does not interfere when those resources are used in other employments.

Interventionism does not abolish private property. The citizens still have ownership and control of their property, even though they have to share both ownership and control with the government and its agents. It is true that this forced co-ownership is usually a matter of degree. Increased interventionism increases the share of government control of resources, though without outlawing other people’s simultaneous control of these same resources. But the forced nature of the co-ownership itself is not a matter of degree. It is a categorical and essential feature of any intervention, be it ever so small.

Government interventionism always and everywhere entails a forced separation of ownership and control. It always and everywhere creates unwanted “partnerships” between the citizens and their government. It follows that, by its very nature, it creates a moral hazard both for the citizens and for the government. Most importantly, it creates a situation in which each of the parties involved (the citizens on the one hand and the government on the other hand) desires to expropriate the resources subject to interventionism at the expense of the other parties. First consider the reaction of the citizens to taxation, regulation, and prohibition.

From the very fact that intervention entails forced co-ownership, it follows that the citizens have an incentive to evade the intervention. They can to some extent evade it because they have some control of their property. To avoid taxation, for example, they can choose to invest capital in a country with low taxes rather than in a country with high taxes; they can choose to emigrate to low-tax countries rather than stay in high-tax places; they can choose a profession that is less taxed than other professions; or they can choose to make fraudulent declarations of their income and capital. To evade regulations, they can choose not to buy or sell commodities subject to price controls, or they can choose to buy and sell them on the black market. To evade prohibitions, they can buy and sell prohibited items on the black market. However, operating on the black market is risky and thus very costly, and evasion to other countries is costly too. Thus it follows that there is an incentive for the citizens to use a greater part of their property for personal consumption rather than invest it. Hence, the general tendency of interventionism on the citizens is to entail excessive consumption and to make production more costly because of the necessity to evade the intervention.

But moral hazard also comes into play on the side of the government itself. Governments rely on the resource use that comes through taxation and regulation. They will therefore tend to tax more and regulate more in order to neutralize the ways in which the citizens evaded its previous intervention. It will seek to “close the loopholes.” We have here a basic mechanism of the dynamics of government interventionism. Interventionist governments have an incentive to extend taxation to all branches of economic life; to regulate industries that have so far escaped regulation; and to beat into submission the countries that serve as tax havens. The ultimate result is to reinforce the tendencies that we characterized above: excessive consumption and insufficient production; in short, a general impoverishment of society.

It is not co-ownership per se that causes these excesses. They are caused by the uninvited and unwanted co-ownership that springs from interventionism.

Notice that our foregoing analysis in no way depends on the existence of asymmetrical information. We can assume for the sake of argument that all citizens are perfectly aware of the government’s activities, and that the government is also perfectly well informed about the activities of all citizens. All of this would not alter the picture. Government interventionism entails moral hazard both on the side of the government and on the side of the citizens. And this moral hazard cannot be neutralized by choosing appropriate contractual devices, because it has no contractual basis at all; it is imposed. It cannot be sidestepped by choosing to avoid the moral-hazard-prone situation altogether, because the situation itself is imposed. The very meaning of interventionism is, as we have said, to overrule the choices of property owners.

And similarly, the workings of moral hazard cannot be eliminated or diminished by correct expectations, as in the case of moral hazard on the free market. The case is exactly the reverse. It is precisely when the citizens correctly anticipate how high the next tax will be, and when it will hit them, that a moral hazard will start bearing on them and incite them to evade the tax.

Let us now turn to the discussion of an important case in which government interventionism produces moral hazard on a large scale: monetary interventionism.

The fundamental intervention, on which all other interventions in this field are built, is the imposition of a legal tender. The latter is a means of payment that the market participants are obliged to accept, even if they made contracts that stipulated payments in terms of other media of exchange. This intervention creates a moral hazard for the market participants to hoard or export the media of exchange that in their eyes are better than the legal tender, but which they are legally bound to use at par with the legal tender. The paradoxical result is that only the legal tender—the medium of exchange that everybody seeks to avoid —remains in circulation. Economists call this phenomenon “Gresham’s Law.”

But fiat paper money also creates moral hazard for citizens, banks, and governments because they sooner or later come to realize that the masters of the printing press have the power to bail out virtually any bankrupt firm or government.

All contemporary monetary systems are based on such legal tender privileges. Paper money—as well as electronic money (“central-bank liquidity”)—does not compete with other monetary products on the free market, but is imposed by special privilege. It is therefore called fiat paper money. This institution is of great interest from the point of view of the theory of moral hazard. In fact it entails moral hazard on the greatest imaginable scale, again, both on the side of its producer and on the side of its users.

Fiat paper money creates moral hazard for the producer because he has the possibility of creating ex nihilovirtually any amount of money and, thus, to buy virtually any amount of goods and services for sale. The only limit to this capacity is the hyperinflation that invariably results in the case of a great inflation of the money supply.

But fiat paper money also creates moral hazard on the side of the money users—the citizens, the banks, and the governments—because they sooner or later come to realize that the masters of the printing press have the power to bail out virtually any bankrupt firm or government. Thus they engage in more or less reckless financial planning, expecting that the monetary authorities will not allow a great mass of reckless planners to go bankrupt. This speculation has been borne out by the last 30 years Public and private debts are at record heights all over the world.

Monetary theorists were aware of this danger early on, even though they did not use the word “moral hazard” in this context.

Here we should mention in the first place all defenders of sound money— that is—of competitive money, such as Ludwig von Mises, F.A. Hayek, Murray Rothbard, and many other economists of the Austrian School.

The idea that rules could prevent large-scale moral hazard in a fiat paper money system defies human logic. After all, the only possible use of a printing press is to produce more money than would have been produced on a free market.

Financial bubbles are the unavoidable result of such a state of affairs. If more or less every major participant to the financial market is subject to moral hazard, then in due time even the smaller traders realize that the bigger fish play the moral hazard card, and thus they too venture to set out on the same path. This means that the market participants sooner or later come to base their plans on the availability of a far greater quantity of goods and services than is really available in the economy. In short, paper money by virtue of its mere existenceproduces massive error on a large scale, until the bubble bursts in a crisis.

Again, as in the other cases of interventionism- induced moral hazard, these effects cannot be neutralized, avoided, or diminished through anticipations. And this means that they cannot be managed through the management of expectations. Mainstream economists have in the past 30 years labored to bring expectations into the picture of monetary policy. The next 30 years will presumably be needed to take account of institutionalized moral hazard. The problem is that our monetary system will not survive that long, if we can extrapolate the speed of the events of the past 30 years.

***

Jörg Guido Hülsmann is senior fellow of the Mises Institute where he holds the 2018 Peterson-Luddy Chair and was director of research for Mises Fellows in residence 1999-2004.  He is author of Mises: The Last Knight of Liberalism and The Ethics of Money Production. He teaches in France, at Université d’Angers. His full CV is here.

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Author: Jörg Guido Hülsmann
Views: Read by 1,116 people
Date: September 7th, 2018
Website: https://mises.org/

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16 Comments...

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  1. Beaumont says:

    Corporate welfare or sponsorship causes moral hazard.

    Solonian timocracy is an antidote.

    Maybe, the Stop Bezos Act will result in a Malthusian check, balancing consumption with expenditures.

  2. john stiner says:

    Ever notice how people claim America is the land of the free?

    It pisses me off when they say that because we are the opposite of free.

    How many of you have a “license” to work?
    How many of you get a building permit to fix your house?

    When you have to get government permission to work or build on YOUR property, that is not freedom. That is government tyranny.

    • Beaumont says:

      Taxation of property is a rent payment, and tribute is not freedom.

      Freedom is an assumption or a state of being, it is not earned, so has no price.

    • Anonymous says:

      Which countries do you propose being more free and why?

      Personally, I can’t think of a country I want to move to in order to be more free, all the others seem to have disadvantages far outweighing any advantages they might have.

      The only way to achieve total freedom is to achieve total isolation, otherwise there is always someone or some organization placing limits on what you can do without question or interference.

      IMO

      • Beaumont says:

        Some dignitaries practice what is called abstentionism. They believe that onerous, legal privileges do exist. They do hold the seat of power but refuse to use it.

        Also, there are countries, which attract lots (!) of foreign wealth, with nominal (just barely) taxation and reporting requirements. They have service industries, and their infrastructure puts ours to shame.

        There are many possible political models, which do not break the first rule of intelligent civilization — never to initiate force.

    • bb in GA says:

      JS:

      It is evil at the center.

      You have to pay property taxes to be allowed to own or occupy lands/houses that you ‘own’ free and clear of debt.

      Oh, you will also be driven from your home, in some jurisdictions, if you have some or all of your utilities disconnected. The Code enforcers will condemn your house and, at the point of a gun, drive you out.

      Simply stated, in the US, if you are cash poor, you cannot own lands or houses long term.

      Evil

      <bb

      • Menzoberranzan says:

        All I can say to that is if they ever come to kick my family off our land and home they would certainly pay a price. The lives of at least the first bunch sent to do the deed would be their payment, and as many after that I could get til I died. As I have prepared for other attacks/scenarios for many years the price would indeed be high on them too. That is a man’s only recourse or leave like a sheep without fighting for what is right.

      • Old Guy says:

        Yes indeed property taxes punish folks who suceed because they do the correct things. And they just voted a millage increase for the school. And the school pays the football coach A quarter of a million per year.

    • repr sleepr says:

      I don’t draw permits anymore. Catchin’ comes before hangin’. My county license expired three years ago.

  3. Maranatha says:

    Essentially every time American natural resources are sold, it’s a moral hazard as of course future or present American citizens will NEED the petroleum, aluminum, coal, uranum, gold, silver, iron, copper, etc at some point.

    No more is being made. That means that all natural resources are declining and it’s unlikely to discover sufficient nneew sources domestically to offset. In other words, the value of all of these is INFINITE.

    However with international trade,the prices are set internationally by comparing their natural resources. This is a terrible fallacy. What happens is this dramatically reduces the value and harms any nation doing so.

    A wise course of action include strategic reserves purchased by the government. In effect, this is precisely the same as buying gold and storing it in Fort Knox. Then you have your national currency backed by natural resources, at which point, currency becomes money.

    So in essence, the federal government could buy all natural resources even crops or finshed goods, and thus create a single demand that guarantees a market and a profit, and then the federal government could elect to sell some to donestic industry or with major surpluses, elect to sell internationally based upon a reasonable price.

    Such actions would stabilize our economy. Simultaneously with tarrifs we would not send natural resources out to be turned into products made by foreigners and putting Americans out of work.

    And the US government already buys domestic products and thus might incur savings. For example with MREs, maybe it’s wise to buy commdities in bulk to set the price fairly and thus reduce military expenditures.

    If you are selling coal and you know the price as it’s guaranteed to have a buyer, this stabilizes the coal industry. It also creates a shortage of coal internationally which at the pleasure and wisdom oif the federal government can elect to sell when the price is high enough.

    Consider pharmaceutcal drugs. If the US government bought all the heart medicine made domestically, then there is never a shortage, the drug companies know it is sold and at a fair bulk price, thus helping all but the worst scoundrels who once could manipulate the price. 99.99999% of Americans benfit.

    That work for all energy as this would make gasoline prices very stable.

    Meanwhile knowing that peak oil has occurred and refusing to buy foreign oil, then NOW we have an impetus to get algae based diesel and ethanol efficiently in operation.

    • Maranatha says:

      Consider the economic benefit of creating American MONEY that has a value based upon ALL domestic natural resources. The risk is not solely based upon one…like gold or silver…but the diversification means less risk and volatility.

      And partially guaranteeing all natural resources are sold to the government at a fair bulk profit, then in effect the American government created a shortage worldwide. And thus other nations are forced to negotiate in order to get these natural resources as now they are not able to buy them directly but have a sole agent who can easily refuse.

      My guess is China and Russia would do likewise and the three would have genuine economic, diplomatic, and political power. It ultimately would help the big three,but harm a nation like Japan.

      It likely would cripple Middle Eastern nations as they do have but a single source of natural resources. Thus it would almost certainly break terrorism potential.

      Europe would be seriously harmed and forced to negotiate, as would Canada and Mexico.

  4. Moral decay is when (((TPTB))) create Towers for WiFi capable of emitting microwaves to make people vomit, get headach, become sterile, deform dna in the eggs within a females ovaries, interfere with nature and destroy it forever. That is moral decay !!!

    _

  5. kay123 says:

    I agree about taxation taking freedom away…..BUT
    WE NEED SOME ESSENTIAL COSTLY ASSETS.

    I hate taxes as much as the next guy. But if I buy
    a home in a nice neighborhood for $300k and my
    neighbor starts a auto scrap yard around his house,
    my home value takes a nose-dive. Home Owner
    Associations are a necessary evil in big cities. In our
    culture a foreign homeowner can buy up several homes,
    rent them out to ghetto roaches who have more US dollars
    than sense.
    If you don’t like high taxes…..stay in the country. You still have
    to pay taxes for the road to get to your house.

    Yes, you have to buy “licenses”. I don’t like that either…BUT
    neither do I want to call a plumber, carpenter, mechanic, beautician,
    barber, housekeeper, brick layer, etc., only to find out that
    person is not qualified to do that job. (Who hasn’t had THAT
    EXPERIENCE)?? Nobody has enough “friends ” who are “ace
    jack-of-all-trades”……especially in a big city. Small towns where
    everyone knows the best tradesmen are few these days…..getting
    fewer.
    The more we grow….sometimes…..the more we lose.
    But… on the bright side……look what we gain in so many other ways.

  6. Old Guy says:

    Ouite often the License requirement doesn’t insure that the licensed person is qualified. What itoften does is give someone a Monopoly and the right to do shoddy work and charge exorbant prices. What you should do is ask for references and check them out. And get mulitpile bids.

  7. Old Guy says:

    If, before undertaking some action, you must obtain the permission of society—you are not free, whether such permission is granted to you or not. Only a slave acts on permission. A permission is not a right.
    Ayn Rand

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