I keep seeing arguments against bailing out companies which might fail during the Coronavirus crisis cite "moral hazard" as a rationale. I want to explain why this is faulty logic.

Thread

Firstly, what is moral hazard?

It is the tendency of insured individuals or firms to change their behaviour as they know the insurer will bear the cost.

Here is the 1963 paper by Kenneth Arrow that brought the term to prominence: https://web.stanford.edu/~jay/health_class/Readings/Lecture01/arrow.pdf

Now let's consider other insurance settings. We have a public fire service, funded by taxes. In the UK, we have a lifeboat service, operated by the @RNLI, which rescues people in danger at sea. We don't leave people to die in order to limit the risk taking of others.

As an aside, the @RNLI is a fantastic charity, and you should consider supporting them. They rescue hundreds of people from the sea each year.

Right, back to business. Let's assume I have a Leonardo di Vinci artwork and I have it insured. Do I now begin risky behaviour because I am insured? Perhaps set-up a candle display around it? No, because the loss (an irreplaceable painting) is still bigger than the compensation.

And so it is with businesses at the moment. Although a state "bail-out" is like an insurance policy, in practice the "excess" is massive. Stakeholders in companies that receive bailouts always face big losses. Shareholders, lenders, employees, and suppliers all take a big hit.

State bailouts aren't a make whole or a free lunch. People using the airlines as an example seem to forget shareholders have already lost ~50-75%. Huge job cuts are coming regardless.

And who exactly do you want to teach a lesson by avoiding "moral hazard". Teach the employees they shouldn't work in a cyclical industry? Teach management, who are rich already and will probably retire? Teach capital markets, where institutional memory only lasts a generation?

And if you do want to teach the "moral hazard" lesson by letting lots of companies go bust, what is the lesson you want to teach? Perhaps don't supply any factors of production to any cyclical industries? Or perhaps that cyclical industries should have huge cash buffers in place?

And even if you have gotten this far, and still want to teach the moral hazard lesson, is it even worth it? Allowing businesses to go bust en-mass has huge welfare implications for society. This was what we learned from the Great Depression. Do you want another Great Depression?

So there you have it. Moral hazard is (a) out of context, (b) not likely to work, and (c) even if it did work, the costs would likely outweigh the benefits.

End.