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Federal Reserve Bank of St. Louis and Poole, William, 1937 June 19- "Balancing Financial Stability, Price Stability, and Macroeconomic Stability: How Important is Moral Hazard?." U.S. Monetary Policy Forum, New York, New York, February 29, 2008, https://fraser.stlouisfed.org/title/485/item/18824, accessed on June 30, 2025.

Title: Balancing Financial Stability, Price Stability, and Macroeconomic Stability: How Important is Moral Hazard? : U.S. Monetary Policy Forum, New York, New York

Date: February 29, 2008
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image-container-0 Balancing Financial Stability, Price Stability, and Macroeconomic Stability: How Important Is Moral Hazard? U.S. Monetary Policy Forum New York, New York February 29, 2008 T here are two ways to view the question that comprises the title for this panel discussion. One concerns the potential for moral hazard issues to decrease stability. The other is the extent to which, cur- rently, the issue in actuality has decreased sta- bility or raised a problem for the Federal Reserve. The potential is clearly enormous. However, I believe that in the macroeconomic policy sphere, actual moral hazard problems today are relatively minor with the exception of a small number of large financial institutions whose managements and investors believe they can count on government assistance should these firms find themselves in deep trouble. Before continuing, and although I have attended my last FOMC meeting, I need to empha- size that the views I express here are mine and do not necessarily reflect official positions of the Federal Reserve System. I thank my colleagues at the Federal Reserve Bank of St. Louis for their comments, but I retain full responsibility for errors. MORAL HAZARD IN MONETARY POLICY I addressed moral hazard in monetary policy in a speech at the Cato Institute last November, “Market Bailouts and the ‘Fed Put.’ ” 1 Let me repeat the gist of that argument. The concept of moral hazard is most easily explained in the context of insurance. The very existence of insurance may change the behavior of the insured person, who becomes less careful in taking care of insured property than he other- wise would if the property were uninsured. Being less careful with others’ property than your own is not moral behavior and is a hazard to the insur- ance company. Some claim that Federal Reserve policy responses to financial market developments should be regarded as “bailing out” market par- ticipants and creating moral hazard by doing so. In my view, this argument is incorrect because there is a benefit rather than a hazard to sound monetary policy that stabilizes the economy. Consider a monetary policy that maintains low and stable inflation. If market participants have confidence in the continued success of that policy, then they need not structure their activities to be robust against a serious outbreak of inflation. Monetary policy does change behavior, but it is not a hazard to the economy that firms and house- holds make their plans on the assumption of continuing price stability. Indeed, one of the arguments for price level stability is precisely that markets will work better and private deci- sions will be more efficient than in an environ- ment of price level instability. Outcomes are more efficient because behavior changes in response to the environment of price level stability. 1 1 http://www.stlouisfed.org/news/speeches/2007/11_30_07.html. 1
image-container-1 The same argument holds for monetary policy actions that serve to stabilize financial markets in the face of market turmoil of the sort that broke out last August. A monetary policy response to market turmoil is an application to modern finan- cial markets of the traditional function of the central bank as a lender of last resort to the bank- ing system. A belief that Federal Reserve policy actions will serve to stabilize the financial system will affect behavior, but not on the whole in a hazardous way. This validity of this assertion is less obvious than the case for price level stability; I will argue the case. When financial markets are generally stable, many firms will decide that they can get along with less capital. All else equal, higher leverage obviously increases risk. Should there be a shock, a firm with less capital is more likely to have dif- ficulty. However, in the more stable financial environment, shocks are less common and less severe when they do occur. If that were not the case, we would not describe the situation as being “a more stable financial environment.” However, whatever the degree of financial stability, nothing protects an individual firm from its mistakes. The Fed’s actions in recent months have not prevented many financial firms from having to write down the value of billions of dollars’ worth of assets. Fed actions have been successful in helping to protect the financial system without protecting any particular firm. A number of hedge funds and mortgage brokers have gone under without a finger of public support being lifted to save them. That is as it should be. Lenders have foreclosed on thousands of homeowners in default on their mortgages and have forced the former owners to leave their homes. So far, we have not seen significant govern- ment funds being supplied to prevent foreclosures, although proposals for such support are common. The public debate on this issue seems pretty healthy to me. People understand the anguish of foreclosure but also the potential moral hazard from bailing out homeowners who took out mortgages they could not afford or from bailing out investors who made loans they should not have made. There is also a widespread belief among homeowners who are meeting their finan- cial obligations that it would be unfair for the government to bail out “irresponsible” borrowers when responsible ones, perhaps with consider- able struggle, are meeting their obligations. As an aside, it seems to me that most of those advocating some sort of government action are supporting relatively narrowly drawn proposals that do not apply to investor-owned houses and to properties already in foreclosure. Whether or not a sound proposal can be enacted that avoids creating moral hazard remains to be seen, but current public debate is sensitive to the issue. TOO BIG TO FAIL In the context of macroeconomic stability, the main moral hazard issue arises in the context of “too big to fail.” I believe that it was Alan Greenspan who put the issue this way: No firm should be too big to fail but some may be too big to liquidate quickly. Suppose a large firm gets into trouble and the potential adverse conse- quences for stability are so great that intervention is unavoidable. In that situation, any intervention ought to take a form such that the costs to share- holders and management are so large that no firm in the future will want to allow itself to fall into such a situation. Lest I be regarded as a soft touch when I say that a situation could arise that could make intervention “inevitable,” I would set a very high bar to any intervention. Here is what I think is sound advice: “Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a ‘clear and present danger.’” Some may be surprised to learn that the author of this sen- tence was Milton Friedman in his presidential address to the American Economic Association in 1967. 2 In recent months, some boards of directors have forced out their CEOs and companies have FINANCIAL MARKETS 2 2 The American Economic Review, March 1968, 58, p. 14.
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Date: February 29, 2008
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