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Nodir Ataev

Professor Jerry Pohlman

EC-315-A Managerial Economics

10 December, 2009

The Economics and Politics of Moral Hazard Revisited

Nicholas Gregory Mankiw, a leading American economist and former chairman

of the CEA, states that policymakers should not ever forget about incentives—

circumstances that motivate people to behave in a certain way—because many policies

change the costs or benefits that people face and, therefore, change people’s behavior

(Mankiw 7). Indeed, a central task of economists is to analyze the nature, causes, and

effects of incentives. It is widely accepted among economists that certain incentives

cause production to increase and others cause production to decrease. One of these

“perverse” incentives is called moral hazard (Hülsmann 35). It is widely held that moral

hazard is a result of asymmetric information (Hubbard, O’Brien 580). However, some

economists like Jörg Guido Hülsmann, who is a leading Austrian School economist, say

there is more to it than just asymmetrical information. In his article The Political

Economy of Moral Hazard that first appeared in the Czech journal Politická ekonomie in

February of 2006, Dr. Hülsmann, a professor of economics at the University of Angers in

France, criticizes the current approach and suggests an alternative. He argues that

information asymmetries are just one among several causes of moral hazard (Hülsmann

35). In this paper, the conventional approach to moral hazard will be discussed. Next,

Dr. Hülsmann’s criticism of the commonly held view and his proposed alternative

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approach will be reviewed. Before that, the meaning and relevance of the issue of moral

hazard today and how it applies in different areas will be reflected on.

WHAT IS MORAL HAZARD

Moral hazard is a consequence of asymmetric information and refers to “actions people

take after they have entered into a transaction that make the other party to the transaction

worse off” (Hubbard, O’Brien 580).1 The expression “moral hazard” has been introduced

into economic analysis by Frank Knight and Kenneth Arrow, but the phenomenon has

been known for a long time. Despite the term, moral hazard is not a moral issue. Rather,

it is a question of economic incentives. If one buys insurance against car theft, he or she

may be less cautious about locking the car, because the negative consequences of vehicle

theft are (to some extent) the responsibility of the insurance company. Dr. Hülsmann

defines moral hazard as the incentive of one person to use more resources than he or she

otherwise would have used, because he or she knows or believes that someone else will

provide some or all of these resources. Dr. Hülsmann also calls attention to the fact that

this occurs against the will of the latter and that he or she is unable to sanction this

expropriation immediately (Hülsmann 35).

MORAL HAZARD IN INSURANCE

Moral hazard is most commonly associated with insurance. In the insurance market, it

describes the danger that in the face of insurance, an agent will increase his exposure to

risk or otherwise will change his behavior and this behavior will make the insurer worse

off. For example, if a firm purchases fire insurance for a warehouse, it may be less

careful about avoiding fire hazards. Similarly, a person with health insurance is more

1. Asymmetric information occurs when one part to a transaction has more or better information

that the other.

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likely to engage in more risky behavior like skydiving or visit the doctor more often for

treatment of even minor problems. To find out how people behave when they have

insurance coverage and when they do not, the Rand Corporation performed a major five-

year experiment. The researchers gave one group of patients a policy providing

essentially free, unlimited care. Another group of patients had to pay their own bills, not

including considerably expensive hospital stays. Not surprisingly, the first group

compiled 45 percent more health care bills than the second group (Buchholz 100).

Consider another example of moral hazard in insurance. If an accident costs a person

$2000 but the insurance coverage pays him or her $1500, the person might be less

concerned about avoiding the accident. If the accident costs the person $2000 and

insurance pays him or her $2500, the person might even hunt for an accident. The

problem of moral hazard also affects government programs that insure people against ill

luck. Unemployment compensation pays people who are out of work. Many programs,

like food stamps and public housing, help people who live in poverty. However, these

policies create problems of moral hazard; they increase unemployment and poverty.

MORAL HAZARD IN FINANCE

In their book Money, Banking and Financial Markets, L. Ritter, W. Silber and, G. Udell

call information asymmetry, which includes adverse selection and moral hazard, public

enemy number one (Ritter, Silber, and Udell 192).2 Although this may be an exaggeration,

the problems of adverse selection and moral hazard are of significant importance in

financial markets. Information asymmetry poses problems for firms and

2. Adverse selection occurs before a transaction because one party has less information than the

other. Moral hazard occurs after a transaction because a party changes its behavior and this change has the

potential of making the other party or parties worse off.

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investors in the markets for financial securities. First and foremost, investors are reluctant

to lend to some businesses because they do not know much about those firms. Also,

almost all small businesses tend to represent themselves as low-risk businesses.

(Investors are more willing to buy stocks and bonds of firms if a great deal of public

information is available about those firms). This is the problem of adverse selection.

Investors also worry about moral hazard after lending. This problem arises because

borrowers covertly engage in activities that increase the likeliness of poor performance.

(Ritter, Silber, and Udell 193-194). For example, firms may pay high salaries to their

managers. A dramatic example of moral hazard occurred in 2002 when users of the Rigas

family, which controlled Adelphia Communications Corporation, the fifth largest cable

company in the United States before filing for bankruptcy, were accused of using more

than $250 million of the firm’s money for personal expenses (Hubbard, O’Brien 582).

Also, a small business borrower may intentionally choose riskier projects after borrowing.

The reason for this is that owners share the profits disproportionately if the firm does well

while lenders share disproportionately if the firm does poorly. The reason for this is that

lenders usually get only principal and interest no matter how well a business performs,

whereas the owner is better off when the firm performs well because he gets the big

profits. On the other hand, because of limited liability, when a business loses money, the

owner loses only the amount that was invested.

Financial intermediaries, which include banks, insurance companies, and pension

funds, play a key role in solving the information asymmetry problem. They produce

information by addressing the adverse selection problem before transactions are

consummated and by monitoring borrowers after transactions to address the moral hazard

problem. Banks, for instance, monitor borrower behavior by issuing not-traded financial

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contracts that are held by the bank until maturity so that the bank can keep a close eye on

its money (Ritter, Silber, and Udell 195).

Financial bail-outs of lending institutions by governments can encourage risky

lending in the future if those that take the risks come to believe that they will not have to

carry the full burden of losses. In other words, moral hazard occurs when profit is

privatized while risk is socialized. Some believe that taxpayers, depositors, and other

creditors have often had to bear at least a part of the burden of risky financial decisions

made by lending institutions. Bill Brown, in his article Uncle Sam as Sugar Daddy, states

that Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are acting like a

“sugar daddy” by “helping resuscitate the banks that are in trouble (and some of those

that are not).”

However, we cannot be sure that financial bailouts of lending institutions

encourage risky lending behavior because lending institutions cannot be sure that a

bailout will take place.

Niall Ferguson, professor of history and business at Harvard University, and

Laurence Kotlikoff, professor of economics at Boston University, point out that the

problem of moral hazard is a global phenomenon. They point out that Dubai World's

recent default shows if proper measures are not taken, banks are eager to lend recklessly.

THE CONVENTIONAL THEORY OF MORAL HAZARD AND DR. HÜLSMANN’S PROPOSAL3

So far in this paper, the issue of moral hazard has been treated as more of a problem of

information asymmetry. It is necessary to note that information asymmetries do not by

3. Dr. Hülsmann is one of the leading modern-day proponents of the Austrian School. He is the

author of The Ethics of Money Production. He has written primarily on monetary reform issues, advocating

a non-inflationary gold standard as the only viable way to control cyclical inflation caused by excessive

bank credit creation.

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themselves create the problems of moral hazard. For this reason, scholars have

conventionally stressed an additional condition that in conjunction with information

asymmetry creates the problem of moral hazard. Specifically, the separation of ownership

and control is an additional condition that creates ground for moral hazard. According to

Nobel Prize laureate Kenneth Arrow, the separation of ownerships and control creates

two kinds of informational asymmetries: hidden knowledge, which results in adverse

selection, and hidden action, which entails moral hazard. In his article The Political

Economy of Moral Hazard, Dr. Hülsmann distinguishes co-ownership and agency

contracts as two cases of this separation.

In co-ownership, one owner has limited control over certain property. Information

asymmetries together with this separation of ownership and control can create moral

hazard. In such cases, parties have an incentive to increase their own monetary and

psychic income at the expense of other parties.

In the case of an agency contract, an agent pursues his own interests rather the

interest of the principal that hired him. Again, the separation of ownership and control

produces moral hazard together with informational asymmetries. For example, a firm’s

top management (agents) may have an incentive to decrease the firm’s profits by

spending money on fancy cars rather than pursue the interests of the principal (the

shareholders of the firm) that hired them.

It is noteworthy that modern theories of moral hazard emphasize the fact that

information asymmetry produces moral hazard only together with the separation of

ownership and control. However, some do not even mention the separation of ownership

and control as a necessary condition for moral hazard to take place. On the other hand,

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Dr. Hülsmann argues that the separation of ownership and control is “indeed the decisive

element, whereas information asymmetries are but a sideshow” (Hülsmann 38).

Specifically, he argues information asymmetries create moral hazard only when

ownership and control of a resource are separated without the owner’s consent. To

demonstrate his argument, Dr. Hülsmann first discusses moral hazard on the free market.

In a free market, people can voluntarily separate the ownership and control of property.

He argues that moral hazard does not necessarily occur when we have separations of

ownership and control together with informational asymmetries. In other words, these

conditions are not enough for one party to enrich himself at the expense of another. There

are powerful forces at work in a free market that work to do away with expropriation.

Therefore, this expropriation is accidental and short-lived. He bases this on the fact that

information asymmetry and the separation of ownership and control find an antidote in

expectations. He uses the principal-agent problem to support this view. For instance, let

us say an owner of a shop hires a new clerk and he cannot control this new clerk’s

behavior. According to the conventional theory, the clerk is likely to behave differently

when he is monitored than when he is not (When not supervised, he can be sloppier).

However, the clerk does not necessarily enrich himself at the expense of the owner. The

reason is that the owner anticipates this behavior and discounts the marginal value

product of poor work. As long as this anticipation is correct, the clerk cannot expropriate

the owner. Furthermore, principals also draw up contracts that help them prevent moral

hazard and decrease its impact if it does happen. For example, in the insurance industry,

coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing

the consumers’ direct spending. Also, in a free market, principals can cancel contracts

when they please. It is not highly desirable to shirk work responsibilities and risk being

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fired. Therefore, according to Dr. Hülsmann, we can conceivably assume that people will

choose work rather than moral hazard.

Dr. Hülsmann argues that, despite economists’ belief that moral hazard results in

market failure even in free markets, there is no other alternative. As Dr. Hülsmann points

out, comparing free markets to an ideal world with perfect information and proclaiming

them inefficient is senseless.

INTERVENTIONISM AND MORAL HAZARD

When property rights are not clearly defined, as with public goods, moral hazard ensues.

Consider fish in the ocean. People try to fish as much as possible. This tendency for a

common resource to be overused is called the tragedy of the commons. In this case,

Dr. Hülsmann argues that information plays no role. Even if everyone knew their fellow-

owners’ activities, there would still be the problem of moral hazard. Actually if this was

the case, there would more likely be moral hazard, since all fishers would be motivated to

take advantage of the common resource and fish even more because they would be aware

that many other people are willing to fish too.

Above the issue of moral hazard when property rights are not clearly defined was

discussed. More importantly, according to Dr. Hülsmann, moral hazard occurs when

there is forced separation of ownership and control. He defines a “forced” separation of

ownership and control as a “separation brought about against the will of its owner”

(Hülsmann 41). The author emphasizes the importance of government-enacted separation

or government interventionism. Government interventionism is different from mixed

economy. “An interventionist government commands other property owners to use their

resources in a different way than these owners themselves would have used them”

(Hülsmann 41). By doing this, the interventionist government becomes the unwanted

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owner of other parties’ property. Dr. Hülsmann states that the essence of interventionism

is institutionalized and uninvited co-ownership. According to him, the government makes

itself the unwanted and uninvited co-owner whenever it taxes, regulates, and prohibits.

Thus, any government interventionism creates a forced separation of ownership and

control. By levying taxes, the government declares itself the owner of a certain share of

property belonging to its citizens. Before taxes are paid, the government imposes itself as

the co-owner of almost all assets of taxpayers. However, the taxpayers control the

resources before the taxes are paid.

By regulating how some resources are used, the government proclaims itself the

co-owner of those resources. Dr. Hülsmann gives minimum wages fixed by the

government as an example of government regulation. Here, the government proclaims

itself the co-owner of workers because it does not allow the workers to work under

conditions they see appropriate. Similarly, the government declares itself the co-owner of

certain resources by prohibiting some ways of using them, as it does by prohibiting the

selling of cannabis for recreational use.

Although government interventionism does not abolish private property, it always

entails a forced separation of ownership and control. This creates moral hazard both for

the government and for the citizens, according to Dr. Hülsmann. On the one hand, the

citizens have an incentive to avoid taxation, regulation, and prohibition, as these all entail

forced co-ownership. According to Forbes, some U.S. citizens choose to give up their

United States citizenship rather than be subject to the U.S. tax system (Lenzner and Mao

131). U.S. citizens and legal permanent residents are subject to U.S. tax on their

worldwide income even if they reside temporarily or permanently outside the United

States. Although this might be an extreme example, this shows that people do try to

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evade government interventionism. Similarly, to avoid regulation, people may choose not

to buy some things that are subject to price controls. Employers may choose not to hire

people if the government sets a minimum wage above the equilibrium price (Sowell 30).

Prohibitions create black markets. The Age, an Australian daily newspaper, reported that

harsh anti-alcohol laws in Pakistan have created black markets for home-made brews.

Trading in black markets and expatriating are risky and costly. Therefore, the citizens are

motivated to use a greater portion of their property for personal consumption as opposed

to investing it. Based on this, Dr. Hülsmann argues that interventionism tends to entail

excessive consumption and more costly production because of the costs of avoiding the

intervention.

The government itself faces moral hazard too. Governments rely on the revenue

that comes from taxation and regulation. As taxation and regulation policies prompt

people to evade them, the governments will try to increase taxes to compensate for the

loss caused by their intervention in the first place. They will attempt to “close the

loopholes” (Hülsmann 43). According to Dr. Hülsmann, interventionist governments seek

to tax as many assets as possible as much as possible. This encourages excessive

consumption and meager production, and this impoverishes society.

Dr. Hülsmann emphasizes the fact that the problems discussed above do not result

from simply co-ownership itself. Rather, they result from uninvited and unwanted co-

ownership. This analysis does not depend on information asymmetry. After all, even if

the government and citizens were perfectly informed about everything, these problems

would not disappear. According to Dr. Hülsmann, government interventionism results in

moral hazard for both the citizens and the government itself and this moral hazard cannot

be neutralized either by contracts or by avoiding a situation that entails moral hazard

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because this moral hazard has no contractual basis and the situation is imposed. “The

very meaning of interventionism is, as we have said, to overrule the choices of property

owners” (Hülsmann 43).

MONETARY INTERVENTIONISM AND MORAL HAZARD

In the last paragraph of his paper, Dr. Hülsmann makes a very interesting point. He

argues that monetary interventionism produces moral hazard on a colossal scale. He

argues that the imposition of a legal tender is a central intervention. Legal tender is a

country's currency that must be accepted as a medium for commercial exchange and

redemption of a debt. This means that even if market participants sign contracts in terms

of other means, they still have to accept the tender. This intervention produces a moral

hazard for the participants to store or export the media of exchange that they believe to be

better than the legal tender. In addition to being a medium of exchange, money has other

functions as well, namely, it is also used as a store of value, a unit of account, and as a

commodity for foreign exchange. If citizens believe a currency is worth more in one of

these functions, they will use this particular currency in foreign exchange or store it. The

result of this will be that only the legal tender that people are avoiding will remain in

circulation. The phenomenon of “bad money driving out good money” under legal tender

laws is called Gresham’s law, after Sir Thomas Gresham (1519-1579), an English

financer. The Encyclopædia Britannica provides us with an illustrative example of this

law. Between 1792 and 1834 the U.S. had an exchange ratio between silver and gold of

15: 1, whereas ratios in Europe were from 15.5: 1 to 16.06: 1. It was profitable for U.S.

owners of gold to sell their gold in Europe and buy silver and bring it back to the U.S. As

a result, the “inferior” money drove out the “good” money—gold was withdrawn from

American circulation.

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Paper money that we use is called fiat money because this money has no intrinsic

value but is established as money by government decree (Mankiw 611). Each paper

dollar in my wallet reads: “This note is legal tender for all debts, public and private.” This

system entails moral hazard on an enormous scale both for its producer and users. It

creates moral hazard for money producers because they can create any amount of money

out of thin air to buy any amount of goods and services. The only thing that limits this is

the threat of hyperinflation that consistently follows reckless printing of money. Fiat

paper money also creates moral hazard for its users because they come to realize that the

owners of the printing press are able to bail them out (It is noteworthy that banks are not

the only users of fiat money, but governments and citizens are money users as well).

Thus, money users have the incentive to engage in more risky activities. For example,

financial bail-outs of lending institutions by governments and/or central banks can

encourage risky lending in the future, if those that take the risks come to believe that the

monetary authorities will not let them go belly up.

Dr. Hülsmann argues that large-scale moral hazard in fiat paper money systems

cannot be prevented by rules or anticipations. He goes on to state financial bubbles are

the inevitable result of these systems. Therefore, if major parties in a financial system are

subject to moral hazard, smaller parties will also jump on the bandwagon. “This means

that the market participants will sooner or later come to base their plans on the

availability of a far greater quantity of goods and services than is really available in the

economy. In short, paper money by virtue of its mere existence produces massive error on

a large scale, until the bubble bursts in a crisis” (Hülsmann 44).

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CONCLUSION

In this paper, the conventional view of moral hazard was discussed. Afterwards, Dr. Jörg

Guido Hülsmann’s new approach to the issue was reviewed.

Dr. Hülsmann’s core idea is that contrary to conventional theory, moral hazard is not a

consequence of information asymmetry. He shows that information asymmetry is just one

among other causes of moral hazard and that information asymmetries result in negative

consequences just accidentally. He advances to argue that government interventionism

also entails moral hazard. Government interventionism results in negative consequences

systematically and they result even if there is full information available. The essence of

The Political Economy of Moral Hazard is that perpetual presence of moral hazard is not

as much an indication of market failure as it is of government failure. He concludes by

saying that negative consequences of moral hazard probably should not be explained by

information asymmetries.

Dr. Jörg Guido Hülsmann has been the only one who has tried to develop this

novel approach to moral-hazard theory. This pioneering work is a clear example of

thinking beyond stage one—he challenges the conventional approach and offers a

plausible alternative. However, more research and analysis should be done to develop this

theory and to show its potential merits. There is substantially more work available on the

conventional theory, which treats moral hazard as an information asymmetry issue, than

on the new approach developed by Dr. Jörg Guido Hülsmann. However, his strong

argumentation and extensive research on the topic show that the conventional approach to

moral hazard may conceivably be an example of a common misconception that has

created massive errors.

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Works Cited

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Brown, Bill. “Uncle Sam as Sugar Daddy.” Market Watch 19 November 2008. 6

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daddy?siteid=rss >

Buchholz, Todd. From Here to Economy: A Shortcut to Economic Literacy. New York:

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Ferguson, Niall and Laurence Kotlikoff. “How to take moral hazard out of banking.”

Financial Times 3 December 2009. 6 December 2009.

< http://www.ft.com/cms/s/0/50664eb8-dfaa-11de-98ca-00144feab49a.html >

"Gresham’s law." Encyclopædia Britannica. 2009. Encyclopædia Britannica Online.

7 December 2009 <http://www.britannica.com/EBchecked/topic/245850/Greshams-law>.

Hülsmann, Jörg Guido “The Political Economy of Moral Hazard” Politická ekonomie

February (2006): 35-47. Available on-line at

http://guidohulsmann.com/pdf/PE_Moral_Hazard.pdf

Hubbard, Glenn and Anthony O’Brien. Microeconomics. New Jersey: Pearson

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Lenzner, Robert and Philippe Mao. “The New Refugees. (Americans Who Give up

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<http://web.archive.org/web/20060227051231/http://www.frissell.com/taxpat/FORBES1.

HTM>

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“Lone Brewer Small Beer in Pakistan.” The Age 11 March 2003. 7 December 2009. <

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Mankiw, N. Gregory. Principles of Economics. New York: Dryden Press, 1998. Print.

Knight, Frank. “Risk, Uncertainty, and Profit.” University of Chicago Press (1921)

Ritter, Lawrence, William L. Silber, and Gregory F. Udell. Principles of Money,

Banking and Financial Markets. New York: Addison-Wesley, 2009.

Sowell, Thomas. Applied Economics: Thinking Beyond Stage One. New York: Basic

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