The Story.
I always like to start my posts with a story, so here I go. Once upon a time there was a prince and a princess…
Nah, not that kind of story, hehe, let me try again :)
Last week one of our friends, I’ll call her Betty, said, “if I run into financial trouble, I can always turn to Esmerelda to help me out.” Esmerelda is a mutual friend.
On the surface, this seems fine, because that's what friends do, they help out other friends. But this kind of financial trouble is not about borrowing $5 for gas money. It's about defaulting on debt worth hundreds of thousands of dollars and losing everything she owns; house, car, etc...
My wife and I think the world of Betty. She is kind, generous, a good earner and a great friend for many years. But Betty has a debt and spending problem. And a case of moral hazard. Let me explain…
Moral Hazard.
Moral hazard is when a person (or group) has an incentive to increase risk and exposure, R&E, because they do not bear the full consequences of that R&E.
- Risk is the probability of something bad happening.
- Exposure is how much money you will lose if that bad thing does happen.
An example of moral hazard:
Say my dad buys me a new car.
I totally wreck my car and dad pays for the damages.
I'm thinking, “if I wreck my car again, dad will pay for the damages again.”
So why would I care about driving my car in a demolition-derby and destroying it, he'll just pay for it, there are no consequences (besides killing myself, haha).
I am suffering from moral hazard when:
- I have an incentive to increase my R&E of wrecking my car (by driving it in a demolition-derby).
- Because I don’t bear the full consequences of that R&E because my dad will pay for it.
Wait, a demolition derby sounds awesome! I'm going to call my dad…
Aaaah, he said he ain’t payin for shit, no fun for me :(
More examples include:
- To make more money, home builders build in high-risk flood areas and sell those homes quickly so they don't bear the R&E of the homes flooding.
- Or in the 2008 financial crisis, when investment banks created and sold poorly valued and risky assets to each other; inflating balance sheets, bonuses and stock prices...and in the end, government debt paid for most of it (plus some write downs).
Consequences of Moral hazard.
One of the big negative consequences of moral hazard is reckless behavior. It encourages a person to take risky bets with little regard for the consequences. But what is even worse, is that a person can suffer from moral hazard, and no help comes to bail them out.
Betty's case.
In Betty's case, moral hazard without the bailout, looks likely. Betty is living paycheck-to-paycheck, she has no emergency cash fund and her debt is five times her income (and she makes a great income). She has two jobs; one full-time and one almost full-time (she got the second job to pay for her spending habits). And she is barely keeping up with her debt payments.
A couple of weeks ago, she cried with joy that she got more hours with her second job, because she needed the extra money to pay for her credit card payments. And several times a week she tells us that she just bought something new; a couch, a ceiling fan, some new house decoration, going out to eat. She calls the spending "Creature Comforts," she says, “I deserve it.”
She tells us that Esmerelda will help her financially. She talks about the government paying off her loans, or her uncle giving her a stake in the family business. None of these things are true, there is no one coming to bail her out. Because no one has the means to do it.
In conclusion.
Suffering from moral hazard encourages people to increase the risk and exposure of doing something bad, with the hope that someone will help them out of that bad position; which is rarely the case. This kind of thinking puts people in financially dire situations that take years to dig out of and leads to a lot of preventable suffering.
Stay frosty people. Thanks for reading.
Reference:
https://en.wikipedia.org/wiki/Moral_hazard
It is a bad idea to believe people will be there to give you support while you endanger your own life.
This often leads to first grade disappointment.
How can you from your mind place your responsibility on someone else? Who knows what the person will be going through by that exact time you expected them to be there for you?
Everyone must learn to manage risk. We all take risk in our daily lives and it I essential that we learn and cope on how to manage and maintain our lives and properties through risk.
This topic seem complex, but the way you have placed it made it interesting to read. Thanks for sharing
“Who knows what the person will be going through by that exact time you expected them to be there for you?”
I like this statement. There's a certain amount of arrogant presumption that comes with moral hazard. Not only is one person assuming that their problems have more value than the other person's problems, now limited resources have to be dedicated to reckless behavior at the expense of responsible behavior.
Great reply and thank you @benie111.
Hi friend, interesting post, I agree with you, but I think there are many comfortable people who just want others to solve their problems. If we are adults we are supposed to assume our consequences but in this case we pass them on to others. To me that's being lazy and shameless.
“many comfortable people who just want others to solve their problems.”
This is a profound statement and I agree. Since the world is composed of scarce resources, we as humans must apply resources efficiently to help people that are in real need. Moral hazard is an impediment to that endeavor and should be mitigated.
Great points @franyeligonzalez.
Excellent insight about one more delusional mechanism of contemporary human minds.
There is a motto in Italian - "Chi vive sperando muore penando" - which roughly translates to "those who live in hope will die in pains". I reckon a major part of the problem is that a certain part of Western modern society is actually fostering the culture of "here and now no matter the price", which is a direct consequence of consumerism and justifies every Betty's Creature Comforts. But it's rife with risk and, as correctly noted, plagued by moral hazard.
"here and now no matter the price."
Wow, this is spot on @lucabarbera. And it certainly doesn't help that many central banks are keeping borrowing rates so low. When there's easy debt, there’s easy spending, with less accountability.