Government bailouts increase moral hazard by engendering a business climate in which companies feel they will be protected from the consequences of poor decisions and risky behavior. Because they no longer fear these consequences – at least not to the level they should – they often fail to take the proper precautions to guard against unnecessary risk. This lack of prudence frequently has far-reaching ramifications, including shareholder loss, insolvency, bankruptcy and dissolution. If decision makers are correct and the government steps in to bail the company out, consequences extend to everyone in society. Taxpayers shoulder the cost of bailouts, which also wreak havoc on government budgets.
Moral hazard occurs when a person is shielded from the consequences of his bad behavior or poor decision making and therefore acts differently than if he had to bear those consequences himself.
A classic example of moral hazard is a driver with a top-of-the-line automobile insurance policy. Suppose this policy carries no deductible and pays for every conceivable car-related misfortune, from peeled paint due to an egg prank all the way to a total loss. Compare this driver to one with a cut-rate insurance policy that features a high deductible and myriad gaps in coverage.
In a perfect world, insurance coverage doesn't affect driving habits, and both drivers take every reasonable step to minimize risk – obeying all traffic laws, parking in safe, well-lit areas and keeping up with scheduled maintenance. In reality, however, the principle of moral hazard asserts that the driver with the generous policy has less of an incentive to ensure that nothing happens to his car, as he knows that his insurance company assumes financial responsibility if something goes wrong.
Government bailouts work the same way. At the beginning of the 21st century, for example, many of the largest banks in the United States acted irresponsibly, making risky loans, trading in risky derivatives and operating inefficiently. A strong economy throughout most of the century's first decade, particularly in the financial and real estate sectors, shielded these banks from damage as a result of their poor decisions. However, as Warren Buffett noted, a receding tide exposes those who have been swimming naked. When recession seized the nation in December 2007, several of the country's bedrock financial institutions plummeted toward insolvency. Were it not for the federal government's intervention, they might not have remained afloat.
The debate continues interminably as to whether these bailouts helped or harmed the economy in the long term. Some analysts charge that large bank failures would have touched off a cascade of economic damage from which recovery would be nearly impossible, making bailouts a necessary evil. Others counter that irresponsible companies should have been allowed to fail, and that more stable and efficient companies would have absorbed their business, keeping the economy afloat and leading to a stronger recovery.
What is certain, however, is that government bailouts during the Great Recession shifted the consequences of bad behavior from the executives who behaved badly to innocent taxpayers. This is moral hazard in a nutshell. Less incentive exists to avoid making a mess when someone else has to clean it up.