Financial crises bring out all sorts
of worms from cupboards. Mostly, these reflect ineptitude, irresponsibility
and unrestrained greed, which are usually responsible for having created
the internal conditions for the crisis, even if there could be other proximate
or external factors that are associated with the crisis. But the strategies
of dealing with any crisis have to confront another huge problem, one
which could even lead to future financial crises: that of moral hazard.
The Palgrave Dictionary of Economics defines moral hazard as “actions
of economic agents in maximising their own utility to the detriment of
others, in situations where they do not bear the full consequences”. In
financial markets, these problems are especially rife because such markets
are anyway characterised by imperfect and asymmetric information among
those participating in the markets.
The moral hazard associated with any financial bailout results from the
fact that a bailout implicitly condones the earlier behaviour that led
to the crisis of a particular institution. Typically, markets are supposed
to reward “good” behaviour and punish those participants who get it wrong.
And presumably those who believe in “free market principles” and in the
unfettered operations of the markets should also believe in its disciplining
powers.
But when the crisis hits, the shouts for bailout and immediate rescue
by the state usually come loudest from precisely those who had earlier
championed deregulation and freedom from all restriction for the markets.
This has been very marked in the current crisis hitting the US economy,
reflected in the failure of major mortgage institutions, insurance companies
and Wall Street banks.
The arguments for bailout are related either to the domino effect - the
possibility of the failure of a particular institution leading to a general
crisis of confidence attacking the entire financial system and rendering
it unviable - or to the perception that some institutions are too large
and too deeply entrenched in the financial structure, such that too many
innocent people, such as small depositors, pensioners and the like, would
be adversely affected.
It is this latter perception that has apparently led to the recent decisions
of the US Federal Reserve that have effectively bailed out several major
financial institutions in the past few months, beginning with providing
a dowry for the failing bank Bear Stearns in its shotgun marriage with
JP Morgan, and then going on to protect and then effectively nationalise
the mortgage holding agencies Freddie Mac and Fannie Mae.
Now, with the collapse of Lehmann Brothers, the looming problems of the
world’s largest insurance company American International Group and as
more large Wall Street banks and finance institutions reveal the full
extent of the problems that they have accumulated in the latest housing
finance boom, the issue of more and possibly even bigger bailouts is likely
to become more pressing.
Each of these huge bailouts is being presented as a once-off, inevitable
move designed to save the system. Alan Greenspan, the former Chairman
of the US Federal Reserve, whose easy money policies were strongly implicated
in creating the speculative bubble that has now collapsed, has stoutly
defended these bailouts and suggested that more may be necessary. In a
recent interview he is said to have declared: “This is a once-in-a-half-century,
probably once-in-a-century type of event. I think the argument has got
to be that there are certain types of institutions which are so fundamental
to the functioning of the movement of savings into real investment in
an economy that on very rare occasions — and this is one of them — it’s
desirable to prevent them from liquidating in a sharply disruptive manner.”
Forget, for a moment, whether this argument is correct, or even whether
it will actually be successful in preventing a wider financial collapse.
Consider instead what sort of signal is sent to those who headed the institutions
that are being bailed out. The really great moral hazard in the financial
system today is not just related to the bailout of the institutions: it
is even stronger among those who are in charge and should be themselves
directly paying the price for taking wrong and irresponsible decisions.
Instead, financial markets are now so structured that those running the
institutions that collapse typically walk off from the debris of the crisis
not only without paying any price, but after substantially enriching themselves
further. Consider, for example, Lehmann Brothers, the major Wall Street
bank which has collapsed essentially because it went on a completely unsustainable
borrowing and lending spree, buying assets with as little of its own money
as possible and without proper due diligence or prudential concern.
Now that the bank has collapsed, its 26,000 employees will lose their
jobs, and most of them are unlikely to find new jobs easily in the current
market context. Since they held 25 per cent of the bank’s stock as employee
stock options, much of their savings is also now valueless.
But the Chief Executive Office of Lehmann Brothers, the man who was at
the helm of affairs during all the period of its completely irresponsible
behaviour, last year received a pay packet of more than $40 million. According
to the terms of his contract, if he is terminated he will apparently receive
more than $63 million as part of his golden handshake. Since the much-publicised
jail terms awarded to some of the Enron managers in the early part of
the decade, CEOs of finance companies and banks have also grown more savvy
in protecting themselves, ensuring that the writing in their contracts
provides for the absence of any personal liability in the event of failure.
And the compensation of those in charge in the financial sector is increasingly
divorced from any relation to the actual effects of their management.
According to a recent report in the Financial Times, compensation for
major executives of the seven largest US banks amounted to more than $95
billion over the past three years, even as the same banks recorded around
$500 billion in losses.
Clearly, therefore, the issue of moral hazard cannot be dealt with only
in terms of faceless institutions that are being rescued with taxpayers’
money. There are individuals – in fact, a relatively small number of individuals
- who were enriched by the boom, who were able to manipulate government
policies, the media and the gullible public to ensure the creation and
prolongation of what was always a speculative bubble that would inevitably
end. And these individuals also appear to have rigged the system to ensure
that they are protected from the adverse fallout when the bubble finally
bursts.
Of course, what is happening in US capitalism today is only a repeat the
pattern of the financial crises that spread across the developing world
in the 1990s and early 2000s. In all those cases, those who were responsible
for the policies and financial actions that created the crisis, and who
were the major beneficiaries of the preceding boom, did not pay the costs
of the crises. These costs were borne by workers who lost their jobs directly
because of the crisis, as well as those who were then affected by the
stabilisation measures imposed to control the crisis, including small
businesses that collapsed because of the high interest rate-tight money
regime that is a typical post-crisis response.
Because those responsible for the crisis do not have to pay for it, they
have no compunctions in once again creating the same conditions – and
in fact that is what is happening now in many of the formerly crisis-ridden
emerging markets.
Now it is in the US that we see how the agents of irresponsible and predatory
finance survive and even prosper as everyone else goes under. So now the
executives are laughing all the way from the bank.