Tag Archives: moral hazard

GM, Banks, Bailouts and Incentives

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With the GM IPO having succeeded so well this past week, the critics and nay-sayers have had to change tunes.  I don’t know that I really see the government investment in GM’s bankruptcy and restructuring as a “bailout”.  I see more as the kind of strategic government intervention that helps the economy that a good government does.  But, in the interests of brevity I’ll go with the common parlance of the critics and refer to the investment in GM as a “bailout”.  To understand my position better, see my post on the GM Tale.

The critics can no longer claim the GM was a waste of money.  The government has gotten back something near half of it’s original loans and equity money. The publicly traded market has now put a value on the remaining share ownership and  while it isn’t at break even yet, it’s very plausible that within a couple years the government could recoup all and even profit. The critics claimed GM was hopeless. They claimed the UAW was too overpaid and wouldn’t cooperate. Wrong again. A $2billion profit in 3rd quarter 2010 when total auto industry sales are still down 25% from 2007 disproves that charge.  The critics claimed it was socialism.  Judging by the strong investor demand for the IPO, it’s apparently the kind of socialism that capitalists want.

But now the critics claim that the whole GM bailout experience being successful sets up the wrong incentives. They claims that more large companies will seek big government bailouts too.  They’re wrong again. What the critics are suggesting is called “moral hazard” in economics.  It’s the idea that managers or firms, if they know they will be rescued or bailed out when things go bad, will start taking excessive and unjustified risks.  Moral hazard is the kind of situation where the incentives are wrong.  It’s what you intuitively expect to happen if you tell somebody to choose their risks, then tell them that the riskier choices have higher possible payouts, and that if the risk turns out OK the chooser can keep all the profits. But if the risk turns out bad, the chooser won’t suffer at all.  Obviously this is a “heads the chooser wins, tails the chooser sticks the loss to somebody else”.  Just as obviously, it’s not a good scenario.  It leads to wild and excessive risk taking and leaves other people to clean up the mess and take the loss.

The GM “bailout” doesn’t significantly increase moral hazard at all, though.  In contrast, our policies towards the large Wall Street banks has increased moral hazard.  Why does a GM bailout not create moral hazard but bank bailouts do? Simple. Despite legal and Supreme Court claims, corporations are not persons.  They do not make choices.  Managers of corporations make choices.  For a bailout or the prospect of a bailout when things go bad to create a moral hazard situation, the decision-maker, the person making the choice must be the one to get bailed out.  That means the manager(s).  Government bailouts create moral hazard when the managers are kept safe and allowed to profit when bets decisions go well and allowed to skate without consequence when their decisions don’t work.

In GM’s case, this didn’t happen.  Senior management lost their jobs.  Both Richard Waggoner and Fritz Henderson, both long-time GM managers who rose to CEO lost their jobs and were replaced by outsiders.  Further, the shareholders of GM got wiped out entirely.  They got zip, nada, zilch from the bankruptcy and turnaround.  In fact, technically, the “old GM” is being liquidated, it’s life over.  The IPO is in fact a new company.  No rational existing manager of another company wants to go through what Waggoner and Henderson did.  They want to avoid it.  No shareholder in any other corporation is looking at GM and hoping they can do the same – get wiped out. There’s no moral hazard setup here.

Where the moral hazard of bailouts has been created is with the banks.  The big banks, particularly JPMorgan Chase, Goldman Sachs, Citi and BofA, were all saved from disaster in late 2008 by the government investing billions more money than they did in GM.  Yet, not a single senior manager of those banks has suffered negative consequences as a result.  Quite the contrary, Wall Street hit record management bonues in 2009.  They actually learned that losing other peoples’ money and getting bailed out was a good thing for them personally.  Further, no common shareholder of those banks has suffered.  In fact, the government went out of it’s way to make sure the bailout didn’t affect dilute common shareholders when the government choose non-voting preferred stock as the way to make the bailout investment.  The bank bailouts – now that’s how you create moral hazard and keep them coming back for more.

 

Moral Hazard and How to Reform Our Financial System – NYTimes.com

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Former Chair of Federal Reserve, Paul Volcker notes both the need for banking industry regulatory reform and that one of the needs to address the “moral hazard” that currently exists in the system.  “Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk” according to Wikipedia.  In the case of banks, it is the phenomenon of “heads the bank wins, tails somebody else loses”.  Since widespread bank failures have economy-wide effects (see Great Depression), society, through the government, has an interest in making sure banks don’t fail.  But, knowing that failure is effectively “insured” against, banks will typically take on more risk than they otherwise would.  Figuring out how to insure depositors against loss and widespread bank failures without creating excessive moral hazard is one of the goals of any financial regulatory reform program.

PRESIDENT OBAMA 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international.

Aggressive action by governments and central banks — really unprecedented in both magnitude and scope — has been necessary to revive and maintain market functions. Some of that support has continued to this day. Here in the United States as elsewhere, some of the largest and proudest financial institutions — including both investment and commercial banks — have been rescued or merged with the help of massive official funds. Those actions were taken out of well-justified concern that their outright failure would irreparably impair market functioning and further damage the real economy already in recession.

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A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established “safety net” undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world’s largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected.

via Op-Ed Contributor – How to Reform Our Financial System – NYTimes.com.

Does insurance raise prices?

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A former student asks:

I have a quick question for you. I would like your take on how insurance affects price in a particular market. My understanding is insurance would increase the number of people of are ABLE and willing to use a good/service. Where I am going with this is… Do you think eliminating insurance in a market that depends on it as the major source of funding would reduce price. For instance if you eliminated health insurance would the price of medical services decrease.

Well, let’s think about this.   First off, in theory, “insurance” wouldn’t or shouldn’t have any effect on either prices or quantity of the underlying goods/services.  This would be because of two reasons. First, “insurance” should provide coverage for events or needs that people don’t want to have happen such as being in an auto accident or having cancer.  The probability of these events happening (which would result in a claims situation) should be independent of whether or not people have insurance.  So the quantity purchased wouldn’t change, and hence neither would price. Or at least in theory they wouldn’t. The second reason in theory is because the presence of insurance you should be just spreading the cost of what will be purchased across a large group of people but not actually changing the total amount available to spend.  But again, this is the theory of insurance.

In practice, we have an additional problem:  moral hazard.  Moral hazard arises to some degree whenever insurance is offered.  One aspect of moral hazard is that the insured person’s behavior changes  because they are insured.  An example is where drivers (documented in some studies) drive more dangerously and take more risks because they are insured.  This changes the probability of a claim.  When this happens it does increase the quantity of the insured products/services that will be purchased.  In healthcare we don’t see this in terms of people choosing to get cancer or some other awful disease because they’re insured,  but we do see people engaging in more risky and less-healthy lifestyles.  So, yes, because of moral hazard there is some tendency for the presence of insurance to increase the demand for the underlying goods/services.

There is another way, though, that is unique to healthcare that serves to increase demand for healthcare services.  When healthcare services are paid for by insurance, we have a third-party paying the bill.  The buyer and reciever of services (the insured patient) not only isn’t paying directly, they usually don’t even know the price of the services they are getting.  Further, the seller (the doctor or hospital) knows the decision-maker (the patient) isn’t paying, someone else is.  So there’s a tendency to order/use more services than would happen if the patient knew the price. This happens when a family takes a child to the doc for sniffles or a cold.  If the were paying or knew the full price of the doc visit they might not go.  Or when a doctor decides to order another test or cat scan just to reassure the patient that everything is being looked at.  I do  believe this effect has definitely increased the usage of healthcare services and thus has increased demand.  It has also removed a check on price increases.

So overall, you are correct. I do think that the presence of insurance in healthcare has resulted in higher consumption and higher prices than would likely happen in the complete absence of insurance.  Of course we need to keep in mind that a complete absence of healthcare insurance is not really feasible or socially desirable since it would mean that anyone unlucky enough to get seriously ill would soon be  bankrupt and probably unable to buy what they need, ultimately increasing death rates.  The key is to get whoever the insurer is ( private firms or government) focused on price and cost control and monitoring of what really works (eliminate the excess consumption of services).   Right now, in the system we have, insurers really try to make money not by controlling costs or usage but by selecting only healthy people to insure and cutting off people who get sick.