I’ll admit it…I sup­port per­sonal respon­si­bil­ity. I don’t want to pay for the irre­spon­si­ble actions of oth­ers. I want peo­ple to suc­ceed or fail based on the mer­its of their actions.

It all makes me sound like a Repub­li­can, doesn’t it?

See, the prob­lem with peo­ple being able to col­lect on suc­cess while not hav­ing to pay for fail­ure is that it cre­ates what’s called a “moral haz­ard”. Peo­ple behave dif­fer­ently when they have lit­tle or noth­ing to lose, and much to gain.

Imag­ine if you could play black­jack, and got to col­lect all win­nings, but only had to pay half of your losses. Sud­denly, you’re dou­bling down on many more hands, and win­ning large sums of money. If you weren’t fully aware that half of your losses were cov­ered by some­one else, you might even con­clude that you’re win­ning due to par­tic­u­larly clever behav­ior on your part, rather than due to the mar­ket dis­tor­tion that arose from the protections.

Moral haz­ards cre­ate all sorts of destruc­tive phe­nom­ena. Per­haps the most sig­nif­i­cant of the past decade came in the real estate boom, which was fueled by a whole series of moral haz­ards cre­ated at nearly every layer of the trans­ac­tion. I’ll talk more about that in a future article.

For now, though, I’ll merely reit­er­ate that I am very much in favor of peo­ple bear­ing the con­se­quences of their decisions.

But we live in a soci­ety, which means that nobody bears those con­se­quences alone.

As a sim­ple exam­ple, let’s say that I bought a house in 2005. I had a good pay­ing steady job, got a 30-​​year fixed mort­gage with 20 per­cent down, and got a decent deal on the house. I did every­thing right, and by the book.

Through no fault of my own, a bunch of other peo­ple bought in the same neigh­bor­hood, get­ting 30-​​year five-​​and-​​one neg-​​am option ARMs with no money down. That’s where they get a mort­gage that, for the first five years, allows them to pay less than the full inter­est pay­ment, on a low teaser rate. After those five years are up, they have to pay as if it were a new 25-​​year adjustable rate mort­gage, with monthly pay­ments of both inter­est and a por­tion of the principal.

These other peo­ple were expect­ing to refi­nance at the end of the five years, get­ting a new mort­gage sim­i­lar to the old one. But they weren’t able to refi­nance, and sud­denly found them­selves unable to make the mort­gage pay­ments. And since they had neg­a­tive amor­ti­za­tion, they owed more on the house than it was worth. Since they couldn’t sell the house, they were forced to go into foreclosure.

A bunch of this hap­pened in my neigh­bor­hood, which brought the value of my own home down to less than I had paid for it. Mean­while, all of these peo­ple had less to spend, given their new mort­gage sit­u­a­tion, and so their reduced spend­ing caused my employer to lay peo­ple off, includ­ing me.

I did every­thing right, and yet I’m being pun­ished because other peo­ple didn’t do every­thing right. So my being respon­si­ble didn’t help me in the end.

Now, given that there is col­lat­eral dam­age caused by other people’s irre­spon­si­ble behav­ior, what should be done about it?

And this is but one example.

We have the med­ical exam­ples as well. Left to their own devices, many peo­ple tend to be med­ically under­in­sured or unin­sured alto­gether. The odds are rel­a­tively slim that they will find them­selves in need of med­ical care that they can­not afford, but a high deductible pol­icy causes huge prob­lems when they find them­selves in need of pay­ing for the big stuff. Do we let these peo­ple die because they rolled the dice and up came snake eyes? If we don’t, then we have already agreed to cre­ate a moral hazard.

We are left, then, with the fol­low­ing choices:

  1. leav­ing untreated those under­in­sured and unin­sured citizens
  2. requir­ing every­one to be covered
  3. treat­ing the under­in­sured and unin­sured, and leav­ing the respon­si­ble peo­ple to pick up the tab

Prior to the PPACA, we chose option 3. As health care costs rose, an ever larger per­cent­age of the pop­u­la­tion became under­in­sured or unin­sured, dri­ving up every­one else’s costs. Elim­i­nat­ing this moral haz­ard requires either every­one to be cov­ered (option 2), or refus­ing treat­ment to the under­in­sured and unin­sured (option 1). I far pre­fer option 2, which is close to the PPACA model.

And what about the other basics, like food and hous­ing? Social safety nets like unem­ploy­ment insur­ance exten­sions and wel­fare pro­grams reduce the urgency of look­ing for work, but what do you do when there are fewer job open­ings than peo­ple who are look­ing for work? At some point, if there is enough of a gap between the num­ber job open­ings and the num­ber of peo­ple look­ing for work, the gap can­not be bridged by mere entrepreneurship.

Seattle’s Hooverville dur­ing the Great Depression

Do we, in that case, choose to allow the unem­ployed to become home­less? If not, how do we avoid cre­at­ing a sit­u­a­tion where peo­ple are trapped in the social safety net?

Ulti­mately, it seems to me that we should avoid cre­at­ing moral haz­ards, but also need to min­i­mize col­lat­eral dam­age when cat­a­stro­phe strikes. Focus­ing on either side with­out exam­in­ing the other is a recipe for disaster.

For exam­ple, the fail­ure of the Fed­eral Sav­ings and Loan Insur­ance Cor­po­ra­tion (FSLIC) in the 1980s arose because the sav­ings and loan insti­tu­tions had their ulti­mate losses pro­tected, which cre­ated a moral haz­ard that they exploited to invest in high-​​risk, high-​​reward real estate, much of it in Texas. When oil prices plum­meted in 1986, the real estate mar­ket in Texas dropped just as sud­denly, and the over­lever­aged sav­ings and loans found them­selves unable to cover the losses. Their cus­tomers didn’t lose their sav­ings, but all of us had to pick up the tab through a fed­er­ally funded bailout.

As I said, I believe in per­sonal respon­si­bil­ity. But I believe that peo­ple need to bear all of their own respon­si­bil­ity. What I don’t want is the elim­i­na­tion of exist­ing sys­tems under the guise of increas­ing indi­vid­ual respon­si­bil­ity, while doing noth­ing to pre­vent extragov­ern­men­tal sys­tem­atic trans­fer­ence of respon­si­bil­ity to others.

In this regard, it is much like I had writ­ten about before regard­ing exter­nal costs. When one can push costs or risks onto exter­nal par­ties, it cre­ates moral haz­ards within free mar­kets.

So how do we pre­vent social col­lat­eral dam­age while sim­i­larly avoid­ing the exploita­tion of moral haz­ards? In other words, how to we ensure that per­sonal respon­si­bil­ity can­not be avoided by inten­tion­ally pass­ing risk onto others?

Any sug­ges­tions?

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