Policy Solutions, Part One of Four

Some think of my book as just another rant against socialism, therefore a rejection of solutions that would involve extensive use of government. But sprinkled throughout the book are not-so-subtle hints of what actions to take and, equally important, which solutions could potentially prove harmful.

What is being missed by nearly everyone in Washington D.C. and by those on Wall Street who were fattened by the bubbles and lobbied hard for a bailout is that the cause of our problem is moral hazard.

Moral hazard is an artificiality, a false signal that contravenes the working of the marketplace, for it severs the age-old relationship between risk and return.

Borrowers and lenders will become ebullient or fearful, and they will always do so in tandem, never in opposition. About the only thing that can constrain excessive behavior is to promote the development of contrary thinkers at both extremes of the cycle.

We desperately need sound banks. There are none, despite what managements in this sector or stress testers will tell you. They all clustered at the edge of employing extraordinary leverage, both on and off their balance sheets, and they exposed themselves to nearly unquantifiable counterparty risk.

They did so because government stepped in to insure deposits, and it preempted the role of safekeeping. The elastic nature of fiat currency intervention at the bottom of economic cycles transmitted a message that systemic risk did not exist any longer.

Yet at exactly this moment, government became least able to provide a backstop to deposits and counterparty failure, because it had leveraged its own balance sheet, whose debts are those of the people (the upper-middle class to be specific -— since they are nearly exclusively called upon to fund government).

Government also succumbed to moral hazard, for legislators felt they could propose and approve spending programs that would be enjoyed by a majority of citizens but be paid for by a smaller, separate group. Like the banker who shifted risk to government and retained the profit, an electoral majority clamored for more stuff: medical care, retirement income, education, lower mortgage payments and down payments, support for almost any social hardship imaginable, as long as somebody else was picking up the tab.

It’s like having a charge card whose bill goes to another person — not necessarily one such as a parent, who out of love would hold you accountable, but a faceless group in another tax bracket for whom you might even hold animosity for their success.

Separating the giving from the getting creates moral hazard. It takes almost inhuman moral fortitude to refuse the largesse. It is not a coincidence that both the private and public sectors would fall prey to moral hazard at exactly the same moment.

It happened because our culture changed over the last century. Our ancient tribal instinct of collectivism returned. We turned away from acknowledgement that an economic and social system operates in another dimension far more complex than that which man can control, and we tinkered with it at our own peril.


Bill Baker,
for The Daily Reckoning

[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy of his book here.]

The Daily Reckoning