There is a debate going on in the blogsphere about whether the moral hazard model is helpful in understanding the financial crisis. One view is that it is not. For instance, Jeffrey Friedman argues that it does not:
First, the moral hazard of "too big to fail" (TBTF). Empirical problem: Before the bailouts, nothing of this scale had ever happened, so no bank could have been sure they would be bailed out. And if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett's Fool's Gold and William D. Cohan's House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn't think they were doing anything particularly risky (an ignorance-based human error), so they didn't even consider the chances of being bailed out.
Second, the moral hazard of "corporate compensation systems," i.e., bonuses.
Empirical problem #1: When this theory took hold, there was virtually no evidence for it (whereas now there is one study for it and one against it)-see Wladimir's and my post on the topic (below).
Empirical problem #2: There was, and remains, the following overwhelming evidence against the theory: 93% of the banks' mortgage-backed securities were either guaranteed by the U.S. government (i.e., Fannie and Freddie) or were rated AAA-the "safest" and *lowest-yielding* securities available. Triple-A bonds are the last thing revenue-seeking, bonus-hungry, risk-indifferent (i.e., risk-knowledgeable, rather than risk-ignorant) bankers would have bought.
Russ Roberts thinks otherwise:
I don't think bankers planned on being bailed out. But I think it affected their decision-making. . . .
Hmmm. Not the best evidence. Do you really expect Jimmy Cayne, the CEO of Bear Stearns to tell a reporter that he threw away his firm's money because he thought he'd get it back from taxpayers? But here's what he does tell William Cohan:
The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you're not exactly like crippled, right?
And then there's this moment from Andrew Haldane, the Executive Director of Financial Stability of the Bank of England:
A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series…
