Monday, July 14, 2008

Moral Hazard and Bailouts

Moral hazard is a concept that economists use to describe how the separation of negative consequences from an individual's actions can lead them to take risks which they would not normally take.

It is the main reason why fathers do not give their daughters access to their credit cards. The daughter, never seeing the bill her father will have to pay, is more likely to go on a shopping spree.

In much the same way, the federal government is now encouraging bad decisions on the part of mortgage companies by bailing them out in times of financial trouble. Earlier this year, the government bailed out Bear Stearns and now they are going to bail out Fannie Mae and Freddie Mac.

This may bring stability to financial markets in the short run, but it will only increase instability in the long run as corporations come to realize that taxpayers will come to the rescue anytime they make a stupid decision.

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