oral hazard occurs when an agreement that people make to act in concert for their mutual benefit results in an incentive for one of them to act immorally. The classic case is insurance. When an insurance company contracts with a homeowner to provide fire insurance, the homeowner now has the incentive to pay a few premiums and then burn his house down and collect a full insurance payout.
In committing arson, not only does the homeowner harm the material well-being of the owners of the insurance company and the innocent homeowners who are abiding by their promises, but he also injures his own spiritual well-being. He has defrauded those who trusted him to keep his word. In response to the possibility of arson, the insurance company assembles an arson investigation team to detect such immoral behavior. Mitigating moral hazard is a wise course of action because it limits the harm to all involved. It would be foolish for the insurance company to overlook the harm of moral hazard or, even worse, to arrange its affairs in a way that augmented moral hazard.
The potential for moral hazard permeates human relationships. Wisdom councils us to look for ways to mitigate the damage of moral hazard and avoid acting in ways that create moral hazard. In one area, regrettably, moral hazard has become a way of life.
Moral hazard is endemic to a banking system regulated by a central bank. Consider the current banking crisis. As reported by economist Peter St. Onge on March 19, the total unrealized losses in the banking system are between $1.7 trillion and $2 trillion. The capital buffer for the entire system is $2.2 trillion. The banking system, therefore, is on the verge of insolvency. Furthermore, there are 186 banks in distress and hundreds with losses bigger and capital buffers smaller than Silicon Valley Bank (SVB).
The main culprit in these losses is the Federal Reserve’s more than decade-long policy of suppressing interest rates. Cheap credit has given an incentive to investors and entrepreneurs to pour funding into all kinds of projects and practices that will prove to be financially unviable. Monetary inflation is the fuel needed to increase the supply of credit and keep interest rates suppressed. The unwinding of the quantitative-easing policies of the Fed after 2014 was quickly abandoned in the repo crisis of 2019. But it was the monetary inflation of the Fed to fund the fiscal explosion of the federal government during the COVID lockdown that has resulted in the current return of significant price inflation. In turn, higher price inflation rates are now causing interest rates to rise.
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