“This is not the time for moral hazard lectures or for lesson administering or for alarm about the political consequences of ‘bailouts’”
Larry Summers, 3/12/23
Apologies, Larry, but perhaps it is the time. Last weekend saw the second and third largest bank collapses in US history. Silicon Valley Bank and Signature Bank both folded in a weekend due to bank runs brought on by gross mismanagement and economic uncertainty. Meanwhile, the Supreme Court appears poised to strike down Biden's student debt forgiveness program. In both cases, the specter of moral hazard has been raised by various observers. But what is moral hazard, and does it really apply here? Let's take a look.
The short version of the SVB story is this: Silicon Valley Bank was, as the name suggests, the primary bank of Silicon Valley, and held billions in venture capital funds from tech startups. Having learned nothing from the 2008 financial crisis and with the freedom provided by Trump's repeal of Dodd-Frank regulations, SVB took on a significant amount of risk while not holding enough capital to cover its accounts. When word got out in the tight-knit network of the Bay Area that SVB could have trouble covering its accounts, panic spread in a matter of hours, leading to a run on the bank, similar to the famous scene in "It's a Wonderful Life". SVB's weakness was also compounded by the failure of ill-advised startups that began during the pandemic and the rise of interest rates.
Meanwhile, President Biden's plan to forgive $1,000 of student loan debt for each borrower looks like it may not survive the Supreme Court. It's worth noting that the Supreme Court may have legitimate reasons to strike down this debt forgiveness, as there are serious concerns about separation of powers and proper procedures in how the program was put into place. However, in the wake of the SVB bailouts, many on the internet have been quick to point out that D.C. was quick to cover the debts incurred by major banks due to their own stupidity, but won't do so for those who simply tried to get an education.
"Moral hazard" is an old scarecrow of an idea that comes up again and again. It refers to a situation where someone has an incentive to take a risk with the knowledge that if that risk fails, someone else (usually the federal government) will pay the costs. Concerns about moral hazard can be raised in all sorts of situations, such as education and healthcare, but this "boogeyman" has especially been raised regarding the student loan bailouts and the current bank balance. However, hardly anyone has raised it for both simultaneously.
In order to see how this concept might apply to bank bailouts and student loan bailouts, let's get to the root of why moral hazard can be a danger to our economy. The idea behind the moral hazard argument is that if there are no consequences for risk, this will increase the amount of risk that's taken and thus increase the potential consequences to the whole economy of that risk. In regards to the first point, demand for college education is remarkably inelastic. It means that as the cost of education has gone up and up, demand has not responded to that increase very much. The demand for college is practically uncoupled from its cost. So why would a slight reduction in the debt of students affect the demand for college so much? And in fact, risk-taking in it. On the other hand, banks very much are my economic calculating machines. They will and do take the potential for a bailout in the case of a large risk backfiring into account. On the second point, let's compare the consequences of these risks. In the case of a student taking a risk, that risk being hoping that the cost of their education will pay off, if the good outcome of that risk occurs, this has a positive externality on the whole of the society by causing a more educated population. If its risk doesn't pay off, the costs are mostly borne by the individual. On the other hand, for banks, the setup is reversed. The extra risk then taken on having enough capital on hand is something that pays off chiefly for the board and stockholders of a bank, not for the whole of society. But if this risk doesn't pay off and it causes a financial crisis, it's something the whole of society faces the consequences for, negative externality.
There is no potential college student out there who is saying, "I wasn't going to go to college, but now because I think my student debt might get bailed out, I am going to get a major in underwater basket weaving." But there are absolutely bankers out there saying, "I'm going to buy a bunch of mortgage-backed securities and risk a financial crisis if this doesn't pay off because I know the government will bail me out."
Moral hazard is often brought up only when discussing issues related to poor people, and it is not always a legitimate concern. It is frequently used or ignored in bad faith, making it practically useless in policy debates. As its name suggests, moral hazard is often someone's own ethical beliefs about work searching for an economic justification. Therefore, I suggest that Larry Summers should discuss moral hazard now and question every time it has been used to prevent something that would benefit those who are not in the financial elite.
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