The Lenders of Hazard
The following passage in a note at The Economist points out to the well-known problem of moral hazard with lenders of last resort. But the moral hazard problem affects more than just the financial institutions:
The European Central Bank (ECB) rejects the idea of acting as a lender of last resort to embattled, but solvent, governments. The fear of creating moral hazard, under which the offer of help eases the pressure on debtor countries to embrace reform, is seemingly enough to stop all rescue plans in their tracks. Yet that only reinforces investors’ nervousness about all euro-zone bonds, even Germany’s, and makes an eventual collapse of the currency more likely.
Usually, moral hazard problems associated with central banks point to the fact that banks and financial institutions will be willing to take more risk than they should. Since, for the financial institutions, a lender of last resort implies a bias, i.e. they keep the gains but share the losses, higher amounts of risk are taken by the banks. The result can be a higher frequency of problems as more risky projects fail more frequently – an inefficient risk-return portfolio.
But an overlook moral hazard problem falls on the side of governments aswell. To the extent that a government can issue bonds that are bought by the financial sector, which is benefited by a lender of last resort, then the moral hazard problem gets channeled all the way to the government. If financial institutions are going to be saved by a lender of last resort, then the governments have all the incentive to issue more debt than they should, sell it to the banks and wait for the central banks to save them all at the expense of the citizens pockets.
It should be noted that it is the presence of a central bank in itself that creates the problem of moral hazard in the first place. Were there no central banks, there would be no moral hazard problems.
Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.
image from heyltje-rose
Nicolás Cachanosky
Dr. Cachanosky is Associate Professor of Economics and Director of the Center for Free Enterprise at The University of Texas at El Paso Woody L. Hunt College of Business. He is also Fellow of the UCEMA Friedman-Hayek Center for the Study of a Free Society. He served as President of the Association of Private Enterprise Education (APEE, 2021-2022) and in the Board of Directors at the Mont Pelerin Society (MPS, 2018-2022).
He earned a Licentiate in Economics from the Pontificia Universidad Católica Argentina, a M.A. in Economics and Political Sciences from the Escuela Superior de Economía y Administración de Empresas (ESEADE), and his Ph.D. in Economics from Suffolk University, Boston, MA.
Dr. Cachanosky is author of Reflexiones Sobre la Economía Argentina (Instituto Acton Argentina, 2017), Monetary Equilibrium and Nominal Income Targeting (Routledge, 2019), and co-author of Austrian Capital Theory: A Modern Survey of the Essentials (Cambridge University Press, 2019), Capital and Finance: Theory and History (Routledge, 2020), and Dolarización: Una Solución para la Argentina (Editorial Claridad, 2022).
Dr. Cachanosky’s research has been published in outlets such as Journal of Economic Behavior & Organization, Public Choice, Journal of Institutional Economics, Quarterly Review of Economics and Finance, and Journal of the History of Economic Thought among other outlets.
