Real world calculus of moral hazard

WORLD VIEW: The banking crisis is an unsustainable socialisation of private loss at public expense

MORAL HAZARD is a major point of debate in the euro zone crisis, especially in Germany. It arises when an individual or institution does not accept the full consequences of their actions, acting less carefully because another party holds responsibility. If I have fire insurance I may have an incentive not to avoid that risk. Strict retributive rules are therefore required to punish transgressors, for the good of the whole.

This is an illuminating way to describe the euro zone’s Stability and Growth Pact (SGP), agreed at a Dublin EU summit in 1996, which said public debt should be no more than 60 per cent of gross national product and budget deficits no more than 3 per cent. But Germany and France broke the rules in 2003-4, when they were amended rather than applied rigorously.

This was a fair-weather construction, as critics point out, without provision for shocks such as the global financial crisis. The rules’ focus on public debt were “blind to systemically dangerous financial behaviour resulting from an abrupt lowering of interest rates as a result of the introduction of the euro”, a report argues this week (see ecfr.eu).

But how relevant is moral hazard if the rules prove to be so deficient? Speaking on the euro zone crisis at the European University Institute in Florence this week the economist Paul de Grauwe said there is no need for a fire brigade if everyone follows the rules scrupulously. But you can’t guarantee that even if they were more comprehensive, since someone will always transgress – the strong case for insurance. Since financial contagion is like a fire it makes no sense to punish the guilty before the fire is extinguished. Solidarity is needed whether you like it or not.

De Grauwe distinguishes between Greece, where moral hazard applies within the SPG rules about public finances, and Spain and Ireland where it emphatically does not because their problems arise from an unsustainable private debt explosion.

The European Central Bank failed to check aggregate bank credit by linking it to the Spanish and Irish property bubbles. Reckless lending by German and French banks makes them sinners too. And yet Ireland is being punished for supposed moral hazard by an EU-imposed interest rate, in a diminished solidarity which undermines economic recovery.

De Grauwe believes the EU’s insurance scheme agreed at yesterday’s summit providing for possible sovereign default is similarly flawed, because it penalises likely beneficiaries by higher rates, thereby inviting financial markets to shun them.

“It is difficult to conceive of a more unstable system,” he says.

In another EUI lecture this week the philosopher Daniel Dunnett spoke about how some scientists say recent breakthroughs in neuroscience undermine individual ethical responsibility. “My brain made me do it,” could then become a plausible legal defence. He recalled Kant’s argument that it would be right to execute prisoners convicted of murder in the few hours before the end of the world because retributive punishment is a collective good. I said to a German friend afterwards “the German banks made us do it”, which raised a smile. Dunnett’s case is that we have a moral competence to choose our actions and must take responsibility for them even if constrained by circumstances.

The same argument applies to the euro zone’s future. In an important political shift this week the German social democratic leadership attacked Angela Merkel’s refusal to collectivise risk by adopting a eurobond system whereby the ECB would take a proportion of each member state’s public indebtedness on to its books, creating a stronger defence against financial market attack. She prefers to emphasise competitive moral hazard.

Making this argument part of German domestic politics brings it home to voters and citizens.

That has happened in Ireland too, as Fine Gael wants to shave €17 billion off the €25 billion unguaranteed senior bank bonds now owed by the Irish State. Proposals for eurobonds, a European Monetary Fund, troubled asset relief programmes, an expanded EU budget, more European Investment Bank borrowings and extra ECB liquidity that have come into the public domain in recent weeks are a welcome politicisation of the euro zone crisis. The ways out of Ireland’s economic predicament are Europe-wide rather than unilateral. They should be debated in the election campaign.

There are no easy solutions. The German social democrats say Ireland has grown partly by unfair tax competition and want to harmonise this sector. That might be the price of a more solidaristic system to ease Ireland’s economic pain – but would the benefits outweigh the costs? The sums need to be done and the arguments, at Irish and EU levels, brought into the open.

The real-world calculus of moral hazard finds European taxpayers bailing out irresponsible banks and vulnerable to irresponsible markets – an unsustainable socialisation of private loss at the public expense. If this is not put right it is unlikely that the EU’s weak but still developing political system can take the strain.