Tuesday, October 28, 2008

Moral Hazard in Action

Here's an example of moral hazard in action where I am the person taking advangate of the moral hazard. 

Recently I bought a 3 month CD from GE Bank at 2.5%. That was the best rate I could find for three-month CDs at the time. I don't really care who I am lending the money to because the government via the FDIC is insuring the CD against any loss. Otherwise, I wouldn't lend a dime to GE because I am not sure it is a solvent entity into the future. That's moral hazard in action. The government has allowed me to privatize the profit if GE stays afloat and socialize the loss if GE fails. 

This guarantee subsidizes GEs debt and allows them to pay a lower rate. By lending GE Bank some capital, that capital is not available to lend to a better institution. In this way, the government subsidy rewards the bad company and punishes the good company. This is a small example of how the government distorts the market and causes capital to be misallocated. This is becoming widespread right now because the government is insuring everything under the sun. Besides the delevaraging that is happening, one of the reasons businesses are seeing the cost of debt rise so much is because the government has made it even easier to buy debt that they have insured. Why should the government expect me to buy buy a corporate bond at 3% when I can make 3% buying FDIC-insured CDs all day long.

1 comment:

Tomek said...

This blog is great. Keep posting.