The Politics of Moral Hazard

The crisis in Cyprus has shown that the true contest in Europe is less between moral hazard and financial stability than it is between financially sensible and politically acceptable solutions. But politics in Europe is national, so what one parliament regards as the only possible solution another regards as entirely unacceptable.

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.

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