In the past few weeks, particularly since the growth of government “stimulus”, there has been increasing talk of the inherent moral hazards of such policies. A close friend, Pia Varma, addressed the issue in an article entitled "I Wanna Rock and Roll All Night....", then I learned of another take on it by Jeff Bezos and by now virtually ever carbon-based life-form living above ground has probably heard of Rick Santell’s now infamous trading floor rant on CNBC. It seems this well-worn, yet heretofore, little acknowledged law of economics is finally gaining some margin of public interest.
We know that “moral hazard” exists. Buts why do mature, intelligent and well-informed people behave in such ways? Is it a cognitive response or is it simply a trait encoded in our psyche?
In its simplest form “moral hazard” is what results when the individual no longer bears sole responsibility for the consequences of his actions. And while we are all prone to such behaviour, not a one of us would admit that we would react this way. The fact is, such behaviour is hardwired in our nature. Therefore we are correct in denying deliberation for we do not do so knowingly or wilfully.
All human beings are guided by a dual nature, one higher, one lower. At our basic level we are much like any other animal in that we act and react instinctively. I do not believe, nor have I seen evidence sufficient to allow me to presume that human behaviour is cognitive though there are certainly times when we naturally think through our actions beforehand and choose the worst alternative. Why? Because our instincts drive our pursuit of the maximum pleasure with the minimum pain. Hence in an economy driven by profit and loss for example, we are encouraged to take risks by the lure of profit and simultaneously encouraged to minimize our risks so as to avoid loss. In other words we take calculated risks. But what happens when we assuage risk to the point of eliminating the consequences of imprudence?
We each have a level of risk with which we are comfortable. One instinctively (as opposed to cognitively) measures consequences involved in a given situation and compensates by adjusting risk exposure to achieve a level thereof commensurate with ones existing comfort level. Such is the premise behind the concept of risk homeostasis.
Consider ultra-cautious, mild-mannered, John. John buys a new Chevy Subcontinent. It’s large, powerful, sits higher than nearly everything else on the road and has the most advanced safety features you could imagine. A vehicle slightly smaller than a Challenger battle tank with roughly the same fuel economy of an aircraft carrier and approximately the same cargo capacity, in cubic feet, as Sri Lanka. So John sits in the cockpit of his new Subcontinent and suddenly he gets a sense of invulnerability. John dispenses with his normal predisposition towards behavioural restraint and proceeds to drive with reckless abandon. Now John isn’t doing this because he doesn’t care about other drivers, nor is he consciously making decisions in utter disregard for the safety of himself or others. No John is merely reacting instinctively to the false sense of security he feels and therefore compensating for the perceived diminutive risk by “pushing the envelope” if you will. The important point here is that this occurs on a purely subconscious level which is to say, instinctively, not cognitively. And once we understand that John is not an aberration, but a normal human being reacting to what he perceives as a low risk situation, we can reasonably predict human behaviour in innumerable circumstances.
When consequences are diminished (even if only perceptively so), people are naturally incentivised to take greater risks. This is just a true in driving as it is in investing and just as true for the janitor as it is for the investment banker.
Therefore, while it is wrong to say that government policies cause specific problems such as the current financial crisis it is entirely reasonable to charge that such policies created an environment wherein individuals and institutions take on risks in ways and to degrees that they would never considered but-for said government policies. That's why we call it the law of unintended consequences. It makes us feel good to protect individuals or entities from the risk of failure or to shield certain persons from the harsh realities of life, but in so doing, we only create conditions wherein greater harm ensues. It's in our nature.
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