EFA (17): Moral hazard

Managing an economy means trying to avoid many hazards, such as high inflation and high unemployment. But there is a special type of hazard that has received a lot of attention recently: moral hazard.

This is the subject of the 17th item in our Economics for Amateurs (EFA) series. You can find the series here each Monday.

So what exactly is moral hazard? The best way to understand it is with the help of an example.

Many years ago, I wrote an article for the English-language magazine Munich Found about cycling in Munich. I recommended that all cyclists should make sure they had personal liability insurance, to insure them against the costs of any accidents they might cause.

But I also wrote that, for their own safely, cyclists should continue to be as careful as they would be if they had no insurance. It doesn't help to get yourself killed and then say (if you could): "But at least I'm insured."

And what has this to do with moral hazard? Well, moral hazard is the danger that people will change their behaviour if they know that they will be protected in some way from the consequences of their actions.

Insurance policies are a classic case. If you are insured — against fire, theft of your car, or whatever — you might be tempted to take greater risks and so increase the likelihood of the occurrence of the thing you have insured yourself against.

To take a different situation, it has also been argued that the compulsory use of seat belts (a form of insurance) could lead to people driving faster than they otherwise would.

The current relevance of moral hazard concerns state bail-outs of banks and other companies that would otherwise go bankrupt (Royal Bank of Scotland, Opel, Karstadt, etc.).

The argument is that, if companies know that the government will step in and help them when they get into financial difficulty, they are likely to take excessive risks. So, by bailing out "systemically relevant" (usually big) companies now, governments are creating potential dangers for the future.