Moral Hazard or Systemic Risk…

September 17, 2008

There seems to be a tension between two of the key notions being bandied around in the crisis.

The notion of ‘moral hazard’ assumes that individuals acting as units will engage in activities (take on greater risk) because they know they are immune from the consequences of these actions (government bail out). Yet the notion of ‘systemic risk’ indicates that there are dynamics larger than individual units at play in the unfolding of events.

The most convincing indication of the tension comes, in how they encode different courses of action, in how they are counterposed as justifications for government intervention.  Creating moral hazard worsens the financial system, but stemming systemic risk is essential.

What is the big story here?  Is the ‘decade of moral hazard’ over as the Financial Times suggests (both in the sense that the Fed refused to bail out Lehman; and in the sense that the crisis might be seen as unraveling an accumulation of morally hazardous behavior)? Or is this about the rise of systemic risk that must be managed?…

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