More Like A Crack Whore

Bill Brown on Uncle Sam as Sugar Daddy:

At the very core of the current financial crisis lies the problem of moral hazard.

Moral hazard is the alignment of incentives that encourages the pursuit of short-term gains with scant regard to (or even responsibility for) potential long-term costs. The U.S. Federal Reserve Bank and the federal government helped create the moral hazard problem, but they are not focused on correcting it. In fact, some recent actions are making the problem more acute.

Former Fed Chairman William McChesney Martin Jr., once said that the role of the Fed was to "take away the punch bowl just as the party got going." But under the leadership of Alan Greenspan, the Fed not only left the punch bowl on the table, it also spiked the punch.

When equity markets wobbled, the Fed came to the rescue. Yet when he commented on the "irrational exuberance" of the equity markets several years ago, Greenspan admitted no role in creating that exuberance.

More recently Greenspan failed to acknowledge the moral hazard problem in a different context. In his Oct. 23 testimony before Congress, he expressed "shocked disbelief" that self-regulation failed -- that financial institutions did not do a better job preventing themselves from getting into trouble.

Greenspan's shock is itself surprising. He was right to believe that markets could be self-regulating, and he was right to believe that markets should work. What he failed to see, though, was that self-regulation couldn't work because of the moral hazard that had crept into the way Wall Street operated.

Many of the problems with Wall Street lie with the corporate structure itself. In the idealized world, management should be acting for the benefit of the shareholders, and the shareholders should act through the board of directors to set compensation and power of management.

In the real world, though, shareholders are too numerous to exert any meaningful control, with the result that management tends to operate in a way that favors itself over shareholders. This moral hazard became particularly toxic in the financial service sector where self-regulation came into direct conflict with self-interest.

On the ruins of the current crash, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are building yet another moral hazard. In the interest of rehabilitating the financial system, they are taking too much of the sting out of the bad decisions of times past.

They are helping re-inflate subprime mortgages and other toxic instruments that got us here in the first place. They are helping resuscitate the banks that are in trouble (and some of those that are not). Most interestingly, they are allowing our government to become a shareholder of recapitalized banks, while permitting the government to fall into the trap of exercising no power over management. The government is acting rather like a sugar daddy who lavishes attention on the basis of flattery, not need.