Monday, November 24, 2014

The Politics of Moral Hazard

BRUSSELS – It is an old and never-ending contest. On one side are the moral-hazard scolds, claiming that one of the major responsibilities confronting policymakers is to establish incentives that demonstrate that imprudent behavior does not pay. On the other side are the partisans of financial stability, for whom confidence in the financial system is too precious to be endangered, even with the best possible intentions.

Cyprus is the latest battleground between the two camps. On March 25, after the decision had been taken to wind up the country’s second-largest bank, and to impose large losses on uninsured depositors in the process, Eurogroup President Jeroen Dijsselbloem, the Dutch finance minister, declared that a healthy financial sector requires that “where you take on the risks, you must deal with them.” The aim, he added, should be to create an environment in which Europe’s finance ministers “never need to consider a direct recapitalization” of a bank by the European Stability Mechanism. He was apparently reading from a textbook on moral hazard.

Immediately after this declaration, however, prices of European bank stocks plunged, and Dijsselbloem was accused by many (including some of his colleagues) of having poured oil on a burning fire. Within hours, he issued a statement indicating that “Cyprus is a specific case with exceptional challenges,” and that “no templates are used” in the approach to the European crisis.

This is not convincing. Markets learn from a current crisis which principles will be applied in the next one. And letting them learn is precisely what the fight against moral hazard is about.

European policymakers have been agonizing over the same dilemma throughout the Cyprus crisis. The burden of bailing out the country’s ailing financial institutions was too heavy for an already-indebted Cypriot state, and the International Monetary Fund was adamant that it would not pretend otherwise. So, in mid-March, Cyprus was heading for a precipitous retrenchment of its banking system, resulting in the loss of a very large part of the country’s financial wealth. For the IMF and Germany, which pushed for such an outcome, the rationale was the need to prevent moral hazard.

Cypriot President Nicos Anastasiades, reportedly with some support from European institutions, desperately tried to avoid this fate – in the name of financial stability. The solution found during the night of March 15 – a one-time tax on deposits – was defensible from the Cypriot viewpoint. Preserving domestic financial stability required limiting taxation of large deposits, because a substantial proportion belonged to foreign account-holders. Avoiding a massive withdrawal of foreign capital therefore implied taxing all deposits below the €100,000 ($130,000) threshold. Absent a foreign bailout, no other solution was on offer.

But this solution was detrimental to financial stability in the rest of Europe, because it signaled that the €100,000 threshold below which deposits are guaranteed was not sacrosanct. Legally, of course, this guarantee is only worth the solvency of the guarantor – in this case the near-bankrupt Cypriot state. But its abrogation would nonetheless be symbolically powerful, sparking anxiety throughout Europe.

The obvious way out of this dilemma would have been for Cyprus’s eurozone partners to assume the cost of the tax on deposits below €100,000. Doing so would have cost them an estimated €1.3 billion, or roughly 0.01% of their GDP – a ridiculously low price to pay for financial stability. It would not have created much moral hazard: large depositors would have been taxed, and the Cypriot government would still have suffered the strictures of an IMF/eurozone program – bitter enough medicine.

But, at a time when northern European citizens are full of resentment against banks and seething with anger over transfers to the south, German Chancellor Angela Merkel and her peers did not want to ask their taxpayers to pay for a partner country’s mistakes.

The March 15 agreement was not politically viable, and was overwhelmingly rejected by the Cypriot parliament. So, ten days after the ill-fated solution was proposed, the Eurogroup ministers changed course and adopted the approach that they had tried to avoid. Banks are being precipitously resolved.

The consequences are already visible: to avoid a complete meltdown, Cyprus has been forced to introduce capital controls – which everyone had thought were illegal and unthinkable within the eurozone. As a result, investors and depositors have learned that the erection of financial barriers within the currency area is indeed a genuine risk. And the Cypriots are so angry at Europe that a deliberate exit from the eurozone has become a distinct possibility.

Ultimately, the true contest is less between moral hazard and financial stability than it is between financially sensible and politically acceptable solutions. In Europe, as elsewhere, financial policy used to be the remit of specialists – central bankers, regulators, and supervisors. Not anymore: the experts have lost their legitimacy.

Nowadays, angry citizens are in charge, and politics is driving financial policy. But politics in Europe is national, and what one national parliament regards as the only possible solution another national parliament regards as entirely unacceptable. Europe has not yet found a response to this problem, and it is not on the way to finding one.

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    1. CommentedKrzysztof Bledowski

      Citizens have the right to be angry. They also are entitled to hear clear and crisp justification for policies proposed and adopted. It's the failure of European policy-makers to make themselves understood that makes the citizenry angry. It's the positive type of anger. Up to the experts to speak clearly to all and be understood.

    2. CommentedJohn Nick

      As long as the natural solution is avoided, we are on the moral hazard ground. Deposit owners should learn that risky banking is subject to potential loss. How about bad bankers ? How about governments ? How will they learn bad banking is a risk ? The deposit owners are actually paying with their money. Which is the corresponding severe measure imposed to policy makers ?
      A key concept in the debate is risky banking. Maybe part of the solution is safe banking.
      Also, risk should be acknowledged. Then why don't we let risk work the natural way ? Maybe because the policy makers would then become directly accountable ?

    3. CommentedCarol Maczinsky

      When you sign up to stability and cause trouble it is you who needs to suffer the consequences and be put back in line. The drama is all hypocrite but the willingness of Cyprus to burn its reputation to the ground is impressive and renegotiation of agreed deals is fun. Let them do that, let them suffer their self-inflicted pains.

    4. Portrait of Michael Heller

      CommentedMichael Heller

      I thought this article was well worth a second reading. Two thoughts:
      1. “the experts have lost their legitimacy” - Could this be because for so long, under the influence of Keynesian theory, they have promised and predicted the chimera of financial stability? They should never have done so. A stable capitalist financial system is a contradiction in terms. Instead they have should have been (and should be now) putting in place the structures that enable societies to ride the waves and take the tumbles. That would include fessing up to populations about the risks of risk. The lesson of financial risk should start in kindergarten.
      2. It’s a shame you been derogatory about “moral hazard” by calling it a form of “scolding”. At least you have mentioned that it is an “incentive”. Traditionally one of the first (if not the first) principles in economics has been that people respond to incentives. The key question becomes -- which is the more useful incentive? The one that tells people to beware of the dangers of real and ever-present hazard (which can cause pain and even death)? Or the one that gives people free or easy money (monetary and fiscal easing despite tight conditions) and says to them, go forth and spend it. Once the crisis is upon them many people are no longer stupid, they will save it.

    5. CommentedZsolt Hermann

      I think if we see it from the perspective of the 99% nobody would think any politician or expert today worries about "moral hazard" any more.
      So far all though the crisis, anywhere it hit in the world, the only concern has been to save the institutions necessary to keep alive the profit making machine, accepting full damage to the public as "collateral damage".
      Of course this is very short sighted, and as a result the human resources, the consumer engine of the over production/over consumption model has already been exhausted.
      We cannot really blame the leaders, the ship is sinking and they try to keep it afloat the only way they know.
      The problem is this ship cannot float, since it has no natural foundations.
      A totally artificial, unnatural socio-economic system cannot be sustained within a closed, finite natural system.
      We need a new "ship", a new system that is based on the laws and principles of integral natural systems, which laws and principles we have to explore and understand first.

        CommentedNorm Bennett

        As I agree with Zsolt Hermann's comment I would also add that when the 99% can no longer afford to purchase and consume anything but the necessities of survival the change will be forced on them. Now is the time to start changing our consumption to that which is necessary and useful for living a more meaningful life. One that looks out for the good of all of Nature, people. resources and all living things. We need to start to learn the Laws of Nature, co-operation and mutual benefit for the good of the system. If we start with changing our education system to teach these principles combined with changing advertizing from consumption to mutual responsibility we still have time to minimize the suffering in the future.

    6. CommentedStephen Stanley

      European citizens resent banks for the same reason Americans outside of the 1% and the political chattering classes do: They are above the consequences of their actions. I do not want to pay for the mistakes of a banker and at the same time I do not want financial instability so there is the resentment: The banker suffers no consequence, nor do the shareholders in the bank, only the taxpayer does.

    7. CommentedStephen Stanley

      And, as is generally the case with these manufactured dichotomies, the truth lies somewhere in between. It's rather disingenuous to resort to this kind of either-or argumentation, particularly on a site where I go to read reasoned discussion of issues.