As Ireland faces major decisions on whether or not to extend the €450bn bank guarantee there is growing questioning of the danger of moral hazard in this process. Moral hazard is the situation in which an individual, or institution or whatever, is insulated from risk while others pay the negative consequences of the risk. In such a situation those insulated from risk have a tendency or an incentive to behave inappropriately. Many argue this is what happened to Ireland’s banks in recent years and are concerned that the same may happen again in the future if much more serious institutional safeguards are not put into place.
This issue is addressed in a chapter of a book to be published by the London School of Economics on August 16th
, 2010, entitled The Future of Finance and the theory that underpins it
. In chapter 10 Peter Boone and Simon Johnson address the issue: Will the politics of global moral hazard sink us again?
They argue that during the last four decades governments in wealthy countries have built up large liabilities because they have provided implicit guarantees to their banks and financial institutions. They estimate that when all government commitments are taken into account, European and US taxpayers are providing implicit guarantees to the financial sector equal to 250% of their total GDP (gross domestic product). This they argue contributes to the development of moral hazard in lending around the world. If this process is allowed to continue then it will lead to large defaults by governments and economic collapse. They also argue that current regulatory reforms will not stop this trend. They conclude with the statement that: “The most worrisome part is that we are nearing the end of our fiscal and monetary ability to bail out the system. We are steadily becoming vulnerable to disaster on an epic scale.”
Peter Boone is with the Centre for Economic Performance LSE. Simon Johnson is with MIT Sloan and the Peterson Institute for International Economics. With James Kwak, they run http://BaselineScenario.com
, a website on the global financial system.