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Larry Summers: Beware Moral Hazard Fundamentalists

Via Mark Thoma. Larry Summers mans the barricades beside John Maynard Keynes:

Central to every policy discussion in response to a financial crisis... is the concept of moral hazard. Unfortunately, there is great confusion.... The term “moral hazard”... It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire.... [I]t is used to caution against creating an expectation that there will be future “bail-outs”....

Moral hazard fundamentalists misunderstand the insurance analogy... the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is “contagion” as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened. In the presence of contagion there is every reason to expect that individual institutions will under-insure because they will not feel obliged to take account of the benefits their insurance will have for others.

Second... solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion. More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive but illiquid projects and reduces the risk of contagion.

Third... much of what financial authorities do in response to crises does not impose any costs on taxpayers... LTCM... no taxpayer money... was spent. A competent lender of last resort... turns a profit....

[P]rudent central banks will make judgments during financial crises not on the basis of “avoiding moral hazard” but rather by asking themselves three questions. First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability...? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.

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