Moral Hazard, illustrated

Wall Street Bailout Bill:
Trickle-down Financial Aid?

As the lead in the movie "Knocked Up" might say, "Moral Hazard, shmoral hazard."

If you've been befuddled by the term -- and seem to be hearing it bantered about lately, in connection with the Wall St. bailout -- think of it this way:

Imagine that, instead of giving Wall Street $700 billion to heal its balance sheets and encourage it to lend again (trickle-down financial aid?), the U.S. government decided to pay everyone's heating bill this winter.* (By the way, such a gesture would arguably be a much better way to address Americans' collective economic distress at the moment.)

The problem with such a "no one left in the cold" government program is that it would create a host of negative side effects and unintended consequences.

Thermostat Settings

If the government were suddenly picking up the nation's energy tab, you'd guess that the utilities might suddenly decide to charge more. Meanwhile, instead of keeping the heat at a conservative 68 degrees (or lower), some people might be tempted to indulge, and set it to a more comfortable 75 degrees.

Since houses vary in size, people's energy bills vary, too; would the program take that into account? For that matter, why should people in chilly Minnesota and Maine get more per capita than Floridians? (Answer: to offset sugar subsidies Florida companies get).

If the government suddenly paid everyone's heating bills, what incentive would homeowners have to spend money on insulation or window repairs?

Finally, lots of people, fortunately, are able to pay their bills without any help. Does the government help them, too? If not, isn't that unfair to people who've saved more of their money, decided to live in smaller, more-energy efficient homes, etc.?

RTC "Round-Trippers"

Now go back to the proposed $700 billion Wall Street bailout.

Who prices the bad debt the government is to buy? What kinds of debt are eligible? Which institutions get to sell to the government? Who is eligible to buy the bad debt? (The Resolution Trust Corp. created to clean up the S&L mess 20 years ago witnessed the unsavory situation of many bankers whose seized S&L's funded inflated commercial real estate on the way up, buying it for cents on the dollar from the RTC on the way down -- call them "round-trippers.")

It keeps going: What kind of quid pro quo does the government get in return? (Equity, salary caps, etc.) Why $700 billion instead of $500B, $1 trillion, or some other number? What assurance do taxpayers have that Wall Street won't quickly ask for more? Etc. , etc., etc.

Besides being incredibly complex, all of the foregoing issues implicate something called "moral hazard": the risk that good behavior is punished, and bad behavior rewarded.

To avoid that, ideally, government bailouts should be reluctant, rare, and no bigger than absolutely necessary. The problem with the latest bailout proposal is that, at the moment, it appears to be none of those things.

*To put in perspective exactly how big $700 billion is, it would likely pay the country's winter heating bills not for one year, but 20!! Feel free to substitute your own, "what-would-$700-billion-pay-for" social program(s) here.