Region Focus

Winter 2003

Jargon Alert

Moral Hazard
By Aaron Steelman

When one thinks of "moral hazard," images of hard ethical issues might come to mind. But to economists, the phrase means something very different: the way insurance affects the behavior of the insured. Abstractly, that is a tough concept to grasp. But there are a number of real-world examples that demonstrate the principle.

First, consider a case that may hit close to home for those with college-aged children. You send your son off to college with, say, $1,000 in spending money for the semester. After one month, he calls home and says, "Dad, I have had a lot of unforeseen expenses and need some more money. How about sending me another $1,000? I promise this will be the last time." If you say no, then your son might think that you're a tightwad. But he'll probably learn to be more prudent with his funds. If you say yes, then he'll probably think you're a great guy. But you can probably expect several similar phone calls the following semester.

Here's another example: How does health insurance alter people's actions? In some cases, not much. For instance, if you have appendicitis, you don't have much choice but to go to the hospital. You would do this whether or not you had insurance. But what if you have a nagging cold? If you're insured, you'll probably go to the doctor and see if there are antibiotics that can solve the problem. If you're not insured, you'll probably make due with over-the-counter medicines and forego the cost of the doctor visit and the prescription drugs.

Insurance companies know this too, of course, and try to protect themselves. One way they do this is through deductibles. If you go to the doctor, you have to pay at least part of the cost; this provides some incentive to minimize health care bills. Another way is through limiting the range of insurance. If you take a dumb risk and get hurt — say, if you go rock climbing without safety gear and fall — the insurance company might not be responsible for your hospital bills.

Take another case, one of substantial interest to the Federal Reserve: the regulation of banks. In general, markets impose discipline on firms. If companies act imprudently, they will likely be punished, in the form of financial losses. And in some cases, bankruptcy may result. In contrast, firms that are managed well and respond to consumer demand usually will thrive. That means that the losses and the gains are felt by the investors and the companies themselves. But all this changes when there is a government safety net, as there is with the banking industry. If a bank acts recklessly, its losses aren't just borne by the bank and its investors; the taxpayers are also hurt. That is because the banks are protected by federal insurance, which reduces the incentives of investors and managers to act prudently. To help correct for the lack of robust market discipline that is present in most other cases, the Federal Reserve and other government agencies regulate banks to safeguard the interests of the public.

Think about the role of government-to-government aid. Bailing out a country that is in the midst of an economic crisis might sound like a good idea. The immediate benefits can be pretty large, after all. But it can set a bad precedent. When countries are plagued by crises, it's usually because their governments have made significant policy errors. By defraying the costs of those errors, the donor countries may inadvertently contribute to the adoption of even more bad policies in the future.

Mexico, for instance, has received significant government-to-government aid over the past century, most recently during the peso crisis of 1994-1995. Allan Meltzer, an economist at Carnegie Mellon University, has written that the effects have been "disastrous for the Mexican economy and its people. Without [bailouts], Mexico would learn to run better policies. There would be less moral hazard, and better results for Mexicans."

Finally, consider the case of natural disasters. Property owners along coastlines and floodplains are, in many cases, covered by insurance provided by the Federal Emergency Management Agency. That means that if a hurricane or flood destroys their houses, the government will help to rebuild them. Without this insurance, those people might reconsider the wisdom of putting their homes in such treacherous areas. But with insurance, they have less to fear because, should disaster strike, part or all of the costs will be picked up by somebody else.

In short, moral hazard problems arise because people tend to be rational and to respond to incentives. Private insurance companies have understood this for years and have tried to tailor their policies appropriately. Governments have been slower to catch on, but hopefully have been learning from past mistakes.


Contact Us

Aaron Steelman
Publications Director

Order Publications

Order single copies of or subscribe to Econ Focus (formerly Region Focus) and other publications from the Federal Reserve System.