How to think about moral hazard during a pandemic

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VSOVID-19 CONFRONTS humanity with a host of trying moral decisions. When hospital capacity is limited, which patients should have access to lifesaving equipment? How long must the virus-limiting restrictions on public activity remain in place, given the immense cost of such measures? To this list, some add another: to what extent should public aid to households and businesses in difficulty be generous, when such aid could encourage the abuse of safety nets provided by the state. ? Concerns like these, about what sociologists call moral hazard, have been relatively alleviated during the pandemic, and rightly so. But the difficult questions of risk and liability cannot be put off.

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Moral hazard describes situations in which the costs of risky behavior are not fully borne by those responsible for that behavior, thus encouraging excessive risk-taking in the future. A fire insurance policy, for example, could cause homeowners to behave more recklessly, such as not changing the batteries in their smoke detectors, as the cost of any damage is partially covered by the insurer. . Concerns about moral hazards often arise during crises, when governments are pressured to rescue ailing institutions for the good of the economy as a whole. Overly generous support for faltering banks could limit the short-term cost of a crisis but could lead to more risk-taking and worse crises in the future, if financiers bet that the government will save their lives again. next time. Walter Bagehot, a former editor of this newspaper, coined his famous lender of last resort rule – lend freely against good collateral in times of crisis, but at a penalty rate – in an attempt to balance these concerns competing.

Rarely has the extent of moral hazard seemed so massive as it is today. To slow the spread of covid-19, countries have shut down much of their economies. And in order to prevent lost sales and jobs from translating into spikes in bankruptcy and poverty, governments have injected huge amounts of aid into households and businesses. Economists of the IMF estimate that governments in advanced economies could run budget deficits that, on average, exceed 10% of GDP in 2020. The US deficit is expected to widen to 15% of GDP. In addition to direct spending measures, many countries have made available a large amount of loans and loan guarantees. Rich countries have extended their aid to others as well, allowing some poor countries to delay paying their debt, for example.

Central banks, too, have acted. For the first time, the US Federal Reserve is buying risky, high yielding debt and bonds issued by state and local governments. He did this in order to prevent the markets from seizing up and leading to cascading failures and economic catastrophe. But its involvement in new markets could change perceptions of risk in the future. Lending standards for some debt securities had already deteriorated in the years leading up to the pandemic. The possibility of a permanent Fed backstop could lead to a lot more borrowing on questionable terms. State governments facing long-term fiscal crises can tackle these problems with less urgency while waiting for Fed assistance, increasing the cost of any future defaults or bailouts. Robert Kaplan, chairman of the Federal Reserve Bank of Dallas, has expressed concern that the Fed’s extraordinary actions could allow institutions that had borrowed recklessly before the pandemic to drop out. Similar concerns have arisen in other contexts. A handful of Republican senators, for example, have worried that more generous unemployment insurance payments could create a host of workers eager to be laid off.

Risky business

Economists, however, have been remarkably relaxed about the moral hazard risks associated with pandemic response measures, for a number of reasons. For starters, these policies protect people and institutions from the full cost of the pandemic by design. Without them, people and businesses could try to get by as usual, spreading the virus and prolonging the epidemic. Timing matters too. Preventing economic devastation and market panic as lockdowns were imposed required massive and urgent action. Interventions designed to minimize moral hazard – by directing aid to the most deserving individuals and businesses and closely monitoring their actions to detect and stop bad behavior – would have distributed aid too slowly and greedily, to avoid catastrophic economic damage.

In addition, moral hazard concerns apply to risks that can reasonably be reduced, for example by putting batteries in the smoke detector. Even the most cautious business or household, however, would find it difficult to withstand a shock that would rob them of nearly all of their income for months. Assistance in these times is less likely to distort future behavior than bailouts are during times of more mundane hardship. Governments can claim that aid is ad hoc, justified by an unprecedented disaster.

Questions of moral hazard, however, cannot be postponed. Some will become more pressing as the pandemic subsides. The economies will need a lot of support to recover. Assistance at this point will need to be carefully designed to provide reasonable assistance while also establishing when the special pandemic era rules no longer apply. While some guarantees or public support cannot be canceled, new supervisory and regulatory capacities may be needed to prevent bad behavior.

In the years since the pandemic, even more difficult choices loom. Covid-19 may seem like a devastating and unique global disaster. But the threat posed by climate change means that such extraordinary natural disasters might not be so rare. It may therefore become more difficult for governments to credibly declare that assistance provided during such disasters is ad hoc, as necessary to discourage reckless behavior and prevent dangerous risks from building up. Governments are right to help without hesitation now, but the years to come will force societies to demand more personal and collective responsibility.

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This article appeared in the Finance & economics section of the print edition under the title “Tough love”