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The Fed Vastly Expands Moral Hazard, Wrecking the American Economy

Politics / Credit Crisis Bailouts Dec 13, 2010 - 03:45 AM GMT

By: Michael_S_Rozeff


Best Financial Markets Analysis ArticleThis definition of moral hazard from Wikipedia is quite satisfactory: "Moral Hazard occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.

"Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company."

Put another way, if people can leave someone else holding the bag (which is a kind of insurance or insulation from a risk), they will engage in greater risk-taking and produce more bags to be held.

Another example is the insurance of bank deposits by the FDIC. These deposits are bank liabilities. If they are not insured, the bank’s capital suppliers, such as bondholders and stockholders, are left holding the bag (which is paying off on these deposits) if its loans fail, which is the risk-taking behavior. If they are insured, these capital suppliers will get the bank to take on greater risks, as in shaky mortgage loans, because others will be left holding the bag if the loans go bad.

When the government bails out banks with shaky loans, it’s providing insurance after the fact. The banks expected it. They expect it in the future. The moral hazard persists and grows larger. They respond by maintaining and making more risky loans.

The government promises all sorts of payoffs and wealth transfers that insure various groups. These all encourage greater risk-taking, which is the effect of the moral hazard. When the government insures people against loss of income in old age by promising Social Security payments, it encourages people to take more risk by not taking their own personal measures to insure their income in old age. People then save less for their old age.

During the bubbly run-up to this recession, a number of markets counted on the "Greenspan put," which meant that the Fed would step in if recession threatened. The Fed was expected to mitigate an ongoing recession or stem the consequences of a financial failure or problem, such as that of LTCM. This understanding acted as insurance. It affected market expectations and behavior. The markets produced more and more and more risky loans and built up an unstable web of connections among financial companies. These depended for their stability on collateral values of risky debt securities, only the markets didn’t look at them as risky because there was a source of outside insurance. The moral hazard produced by the Greenspan and then the Bernanke put showed up in the multiplication of risky loans and a shaky financial structure.

The Fed produced moral hazard all along Wall Street and all along the chain of financial companies across the nation that connected mortgage borrowers to banks, mortgage companies, bond raters, investment bankers, and the Fed itself.

Once the loans began to go bad, the shaky structure fell apart. The Fed responded as the lender of last resort, which really means the insurer of last resort, which really means the entity that produces the moral hazard and then attempts to stem the effects of its own actions by more inflation. It shifts the holding of the bags to the general public and to the taxpayers.

The public and taxpayers are the ultimate bagholders in all this. The moral hazards produced by government and the Fed that lead to shaky financial structures and failures look to both the general public and taxpayers as the insurers or payers of last resort. Greenspan could not in reality provide a put or insurance policy. The Fed can’t provide any real resources, since all it does is print money. The government can’t provide any real resources or wealth because it simply collects them from taxpayers. No, in the end, the general public pays through reduced dollar values (higher prices), and the taxpayers are made to pay through higher taxes.

This brings us to the latest rounds of inflation by the Fed that are called QE for quantitative easing. QE is an invented euphemism for the creation of fiat money by the Fed. The Fed buys securities and pays for them with e-credits that it creates with the push of a keyboard button. This benefits various immediate recipients, but most of us are not in that group. Most of us find that prices are rising and the value of our dollars has fallen. Suddenly a pound of pork sausage that used to cost $2.75 costs $3.75 and then, lo and behold, it costs $4.25, all in the space of two or three years.

In the previous bubble, the Fed produced vast moral hazard in the private debt markets. When the cash flows (the mortgage payments) that held up those securities dropped or were lacking, the values of those securities dropped. Firms began to flop. The system started to fall apart. The Fed "saved" it for another go around the track by massive infusions of credit.

The Fed since 2008 is now again vastly expanding the moral hazard. Where before the credits were interconnected in the banking-investment banking arenas, and still are, they now have a new and larger locus: the government bond markets. The latest round of fiat money-creation has the Fed buying a gross amount of $900 billion of U.S. securities and a net new amount of $600 billion. Bernanke says more may come, depending on how he and the FOMC assess conditions.

The Fed is helping the U.S. government issue vast amounts of new debt. That allows the U.S. government to maintain and increase its spending. The spending programs are analogous to the shaky loans that the banks made. These programs involve huge amounts of waste. They do not produce the cash flows necessary to service the debts being incurred. That’s analogous to the banks that made bad loans that produced inadequate cash flows. In the government case, their spending programs, financed by huge increases in government debt, are not going to produce tax revenues high enough to service the debt.

The Fed is supporting a new locus of moral hazard, which is in the U.S. government’s spending. The Fed is acting as a kind of insurer of this government’s debt, assuring its market and assuring that the debt securities will not decline seriously in price. But if the government spending is largely waste and does little or nothing to produce future cash flows, the cash flows via tax revenues won’t be there to pay off this debt in real terms. What has to happen is that the value of these securities and that of the dollar must decline in real terms.

The Fed will inflate, just as it did in 2008, when the next financial crisis erupts. That crisis will be one of a financial crunch occurring in the U.S. government. The U.S. government will be the next Lehman Brothers or Bear Stearns. This threatened failure event will be vastly larger than in 2008 because of the importance of the government in the domestic and world economies, because of the importance of the dollar in those economies, and because of the links of the Fed and U.S. securities to foreign central banks that hold these securities as reserves.

To save the system in the coming credit stringency to be experienced by the U.S. government, the Fed will try more inflation. The government will, in order to save itself and its system, take all sorts of stringent measures that we will all hate.

How that ends up is anyone’s guess. The chance of a smooth transition to a "reset" of the system on a sound basis is small. The chance of some very large wealth redistributions is high. The chance that those in power gain even more power is high, although the size of their domain may shrink. The chance of government cutbacks is high. The chance of government seizures of private wealth is high. The chance of much greater inflation is high. The chance of the Fed reversing course because of rising prices is very small.

On top of the financial doom that lies ahead for the U.S. government is the financial doom already facing many states, such as Illinois, New York, and California. Their precarious condition ties in with that of the federal government. They will look for bailouts and ex post insurance for their operating and financial mismanagement of the past 10+ years. This pressures the federal government and the Fed.

The financial situation from 2007 to now is seamless. The country is still in recession. It still has the same kinds of financial problems. The banks have still not been straightened out. Their bad loans remain. The government’s housing operations are still bleeding cash. Now we have the states bleeding, and we have a vast moral hazard operation in the federal government, aided and abetted by the Fed. We are in the midst of a prolonged financial crisis brought about by fiat money expansion that, among its many wicked effects, expands moral hazard in whatever directions that money flows. Right now, it’s flowing to the federal government.

If it were not Fed Chairman Bernanke presiding over the blowing of the government bubble, it would be someone else. But he is peculiarly fitted for the job. He was in fact chosen to do it by those who knew his views and knew that more inflation would be required to keep the system afloat a little while longer.

I’d bet on the Congress continuing to spend, and spend, and spend. I’d bet on Congress continuing to add more and more to the national debt. If and when interest rates start to rise, the crunch will come. At that point, I don’t think Congress will suddenly get religion and initiate a sound system. Instead chances are high that it will use force to try to save the system. That force will fall upon most of us, if it happens.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire.

    © 2010 Copyright Michael S. Rozeff - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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