Moral Hazard

The rescue of the financial giant AIG by the Federal Reserve during the financial crisis of 2008 probably prevented a global financial catastrophe and probably prevented the "Great Recession" from becoming another "Great Depression". As bad as it was, with the assets of the U.S. middle class being all but wiped out and millions of people losing their jobs, it could have been a lot worse and lasted a lot longer.

The financial crisis was caused by poor management of large international banks and other businesses that aren't technically banks but function like banks. They took huge risks. When the bubble burst, they were in danger of going bust and causing everyone else to go bust along with them.

The Dodd-Frank law that Congress passed after the financial crisis is supposed to fix that by prohibiting the banks from taking excessive risk. Large banks that are big enough to cause another financial crisis get increased attention from the Federal Reserve. But one part of the Dodd-Frank law prohibits the Federal Reserve from ever again rescuing large banks and financial institutions. The reason given for this change is the danger of "moral hazard", which means, if the banks think they will be rescued in a financial crisis, then they won't care how reckless they are.

The argument, however, ignores the fact that banks and bank-like companies are run by executives. It assumes that these executives care if the bank fails or is rescued by the Federal Reserve. They don't, not very much.

These executives are fairly wealthy. They are clever about money and keep some of their money in gold and other things that guarantee they and their families will be OK in any financial crisis. This leaves them free to gamble with the bank's money without much risk to themselves. If they are lucky, their gambling will pay off and they will make even more money. If they are unlucky, the bank will go broke, but they won't suffer much as a result. This is called "heads I win, tails you lose", and it's the real "moral hazard". Dodd-Frank does nothing to change this.

So we are doomed to endure another financial crisis sooner or later. The next time, though, the Federal Reserve will not have the power to rescue us and we will all end up beggars.