The Fed Vastly Expands Moral Hazard

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This definition of moral hazard from Wikipedia is quite satisfactory:

occurs when a party insulated from risk behaves differently
than it would behave if it were fully exposed to the risk.

hazard arises because an individual or institution does not take
the full consequences and responsibilities of its actions, and therefore
has a tendency to act less carefully than it otherwise would, leaving
another party to hold some responsibility for the consequences of
those actions. For example, a person with insurance against automobile
theft may be less cautious about locking his or her car, because
the negative consequences of vehicle theft are (partially) the responsibility
of the insurance company."

Put another
way, if people can leave someone else holding the bag (which is
a kind of insurance or insulation from a risk), they will engage
in greater risk-taking and produce more bags to be held.

Another example
is the insurance of bank deposits by the FDIC. These deposits are
bank liabilities. If they are not insured, the bank's capital suppliers,
such as bondholders and stockholders, are left holding the bag (which
is paying off on these deposits) if its loans fail, which is the
risk-taking behavior. If they are insured, these capital suppliers
will get the bank to take on greater risks, as in shaky mortgage
loans, because others will be left holding the bag if the loans
go bad.

When the government
bails out banks with shaky loans, it's providing insurance after
the fact. The banks expected it. They expect it in the future. The
moral hazard persists and grows larger. They respond by maintaining
and making more risky loans.

The government
promises all sorts of payoffs and wealth transfers that insure various
groups. These all encourage greater risk-taking, which is the effect
of the moral hazard. When the government insures people against
loss of income in old age by promising Social Security payments,
it encourages people to take more risk by not taking their own personal
measures to insure their income in old age. People then save less
for their old age.

During the
bubbly run-up to this recession, a number of markets counted on
the "Greenspan put," which meant that the Fed would step
in if recession threatened. The Fed was expected to mitigate an
ongoing recession or stem the consequences of a financial failure
or problem, such as that of LTCM. This understanding acted as insurance.
It affected market expectations and behavior. The markets produced
more and more and more risky loans and built up an unstable web
of connections among financial companies. These depended for their
stability on collateral values of risky debt securities, only the
markets didn't look at them as risky because there was a source
of outside insurance. The moral hazard produced by the Greenspan
and then the Bernanke put showed up in the multiplication of risky
loans and a shaky financial structure.

The Fed produced
moral hazard all along Wall Street and all along the chain of financial
companies across the nation that connected mortgage borrowers to
banks, mortgage companies, bond raters, investment bankers, and
the Fed itself.

Once the loans
began to go bad, the shaky structure fell apart. The Fed responded
as the lender of last resort, which really means the insurer of
last resort, which really means the entity that produces the moral
hazard and then attempts to stem the effects of its own actions
by more inflation. It shifts the holding of the bags to the general
public and to the taxpayers.

The public
and taxpayers are the ultimate bagholders in all this. The moral
hazards produced by government and the Fed that lead to shaky financial
structures and failures look to both the general public and taxpayers
as the insurers or payers of last resort. Greenspan could not in
reality provide a put or insurance policy. The Fed can't provide
any real resources, since all it does is print money. The government
can't provide any real resources or wealth because it simply collects
them from taxpayers. No, in the end, the general public pays through
reduced dollar values (higher prices), and the taxpayers are made
to pay through higher taxes.

This brings
us to the latest rounds of inflation by the Fed that are called
QE for quantitative easing. QE is an invented euphemism for the
creation of fiat money by the Fed. The Fed buys securities and pays
for them with e-credits that it creates with the push of a keyboard
button. This benefits various immediate recipients, but most of
us are not in that group. Most of us find that prices are rising
and the value of our dollars has fallen. Suddenly a pound of pork
sausage that used to cost $2.75 costs $3.75 and then, lo and behold,
it costs $4.25, all in the space of two or three years.

In the previous
bubble, the Fed produced vast moral hazard in the private debt markets.
When the cash flows (the mortgage payments) that held up those securities
dropped or were lacking, the values of those securities dropped.
Firms began to flop. The system started to fall apart. The Fed "saved"
it for another go around the track by massive infusions of credit.

The Fed since
2008 is now again vastly expanding the moral hazard. Where
before the credits were interconnected in the banking-investment
banking arenas, and still are, they now have a new and larger locus:
the government bond markets. The latest round of fiat money-creation
has the Fed buying a gross amount of $900 billion of U.S. securities
and a net new amount of $600 billion. Bernanke says more may come,
depending on how he and the FOMC assess conditions.

The Fed is
helping the U.S. government issue vast amounts of new debt. That
allows the U.S. government to maintain and increase its spending.
The spending programs are analogous to the shaky loans that the
banks made. These programs involve huge amounts of waste. They do
not produce the cash flows necessary to service the debts being
incurred. That's analogous to the banks that made bad loans that
produced inadequate cash flows. In the government case, their spending
programs, financed by huge increases in government debt, are not
going to produce tax revenues high enough to service the debt.

The Fed is
supporting a new locus of moral hazard, which is in the U.S. government's
spending. The Fed is acting as a kind of insurer of this government's
debt, assuring its market and assuring that the debt securities
will not decline seriously in price. But if the government spending
is largely waste and does little or nothing to produce future cash
flows, the cash flows via tax revenues won't be there to pay off
this debt in real terms. What has to happen is that the value of
these securities and that of the dollar must decline in real terms.

The Fed will
inflate, just as it did in 2008, when the next financial crisis
erupts. That crisis will be one of a financial crunch occurring
in the U.S. government. The U.S. government will be the next Lehman
Brothers or Bear Stearns. This threatened failure event will be
vastly larger than in 2008 because of the importance of the government
in the domestic and world economies, because of the importance of
the dollar in those economies, and because of the links of the Fed
and U.S. securities to foreign central banks that hold these securities
as reserves.

To save the
system in the coming credit stringency to be experienced by the
U.S. government, the Fed will try more inflation. The government
will, in order to save itself and its system, take all sorts of
stringent measures that we will all hate.

How that ends
up is anyone's guess. The chance of a smooth transition to a "reset"
of the system on a sound basis is small. The chance of some very
large wealth redistributions is high. The chance that those in power
gain even more power is high, although the size of their domain
may shrink. The chance of government cutbacks is high. The chance
of government seizures of private wealth is high. The chance of
much greater inflation is high. The chance of the Fed reversing
course because of rising prices is very small.

On top of the
financial doom that lies ahead for the U.S. government is the financial
doom already facing many states, such as Illinois, New York, and
California. Their precarious condition ties in with that of the
federal government. They will look for bailouts and ex post insurance
for their operating and financial mismanagement of the past 10+
years. This pressures the federal government and the Fed.

financial situation from 2007 to now is seamless. The country is
still in recession. It still has the same kinds of financial problems.
The banks have still not been straightened out. Their bad loans
remain. The government's housing operations are still bleeding cash.
Now we have the states bleeding, and we have a vast moral hazard
operation in the federal government, aided and abetted by the Fed.
We are in the midst of a prolonged financial crisis brought about
by fiat money expansion that, among its many wicked effects, expands
moral hazard in whatever directions that money flows. Right now,
it's flowing to the federal government.

If it were
not Fed Chairman Bernanke presiding over the blowing of the government
bubble, it would be someone else. But he is peculiarly fitted for
the job. He was in fact chosen to do it by those who knew his views
and knew that more inflation would be required to keep the system
afloat a little while longer.

I'd bet on
the Congress continuing to spend, and spend, and spend. I'd bet
on Congress continuing to add more and more to the national debt.
If and when interest rates start to rise, the crunch will come.
At that point, I don't think Congress will suddenly get religion
and initiate a sound system. Instead chances are high that it will
use force to try to save the system. That force will fall upon most
of us, if it happens.

13, 2010

S. Rozeff [send him mail]
is a retired Professor of Finance living in East Amherst, New York.
He is the author of the free e-book Essays
on American Empire

Best of Michael S. Rozeff

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