The multiple moral hazards of central banking

– March 12, 2015 Reading Time: 3 minutes

In an introductory economics course, students are taught that there is “moral hazard” in the incentives of commercial banks because of access to the “safety net” offered by central banks and the government’s guarantee/insurance of bank deposits.

There are a couple dimensions to this.

One is that bank managers have less concern about the liquidity of their earning assets when they know that in the event of a “run” on the bank by depositors the bank can borrow from the central bank. The safety net also includes “finality” of clearing from other commercial banks because if the other bank gets into trouble the central bank will still extend to the receiving bank whatever they are owed. Finally, depositors pay little attention to the quality of the loans and securities of the bank–or the amount of capital the bank has–because deposits are guaranteed.

All this serves as justification for supervision and regulation of commercial banks; the idea is to alter behavior in the presence of moral hazard so that bank management behaves as it would if there were no central bank, no safety net, and no moral hazard.

Wikipedia begins their definition of moral hazard this way: “In economics, moral hazard occurs when one person takes more risks because someone else bears the burden of those risks.” Before central banks and the safety net, banks held three or four times as much equity capital–they were much less leveraged–because they had to bear any losses and be able to provide liquidity in the event of runs by depositors.

Usually, that is about all the young student of economics is expected to learn. However, there are at least a couple more very important ways in which the behavior of central banks introduces moral hazard into the financial system.

Much of David Stockman’s 2013 book, “The Great Deformation” documents the many ways the central bank alters the perceived risks and rewards–and therefore the behavior–in equity and bond markets. He details multiple instances in which participants in these markets have been conditioned to believe that in the event of a sharp decline of common stock or bond prices, the monetary authorities will rush in with massive amounts of central bank cash to drive prices back up. The result is that traders in these markets minimize concerns about downside risk and over-value upside risk–compared to what their judgment would be if the central bank either did not exist or could not be counted on to behave this way.

As we have seen in recent decades, booms and busts in financial markets have become more extreme and more frequent as “irrational exuberance” causes “overshooting” in stock and bond market rallies, followed by sharp declines–until the monetary authorities step in and spike the punch bowl again.

There is a third significant way in which central bank behavior introduces moral hazard in the economic system. Recently, the European Central Bank initiated a well-publicized program of government bond purchases to “stimulate” faster economic growth. However, as the Wall Street Journal commented last week:

The problem is that Europe’s companies have too-little reason to invest in growth when doing so subjects them to complex and expensive labor laws, regulations and high taxes. Mr. Draghi (president of the ECB) recognizes this and peppers his public speeches with pleas to enact supply-side economic reforms… Europe’s political class doesn’t want to do that heavy lifting, so it relies instead on Mr. Draghi’s monetary policies to spur growth. The more aggressive he is, the more the politicians conclude they can do less.

This is moral hazard in the political system–the people’s elected representative do not make the difficult–and often politically unpopular–decisions to remove the “sand in the gears” and restore smooth functioning of market mechanisms that will attract and better allocate investment capital so as to foster greater employment opportunities and sustainable prosperity. Ironically, the presence of the central bank–and lots of belief in or at least hopes and prayers about its powers–means the rest of government is even slower to adopt and implement needed structural reforms. Instead of speeding up the pace of economic activity, relying on the monetary authorities to get the job done without essential fiscal and regulatory reforms, prosperity is further delayed.

Jerry L. Jordan is a Senior Fellow with the Fraser Institute and an Adjunct Scholar with the Cato Institute. He was President of the Federal Reserve Bank of Cleveland, a member of President Reagan’s Council of Economic Advisors, Dean and Professor of Economics at the University of New Mexico, and Chief Economist for two commercial banks. He has also served as Sr. Vice President and Director of Research at the Federal Reserve Bank of St. Louis and as a consultant to the Deutsche Bundesbank in Frankfurt, W. Germany.

Jordan earned his Ph.D. in Economics at the University of California, Los Angeles and his B.A. in Economics at California State University, Northridge. He holds honorary doctorates from Denison University, Capital University and Universidad Francisco Marroquin.