Time consistency is also a useful way to understand moral hazard

Moral Hazard is one of the most discussed topic in the ongoing crisis. Some say the intervention leads to moral hazard, some deny it. This post is about understanding moral hazard in another fashion.

We usually understand moral hazard from the angle of information asymmetry. This was a result of great analysis by Akerlof. Wikipedia explains:

Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Another very useful way to understand moral hazard is from the angle of time consistency models developed by Finn Kydland and Ed Prescott. They got Nobel Prize in 2004 for their work. (Read Mankiw’s superb primer on the topic). I was reading this Nobel Committee primer explaining Kydland-Prescott work and it struck me that this can be modelled to understand moral hazard as well.

Bernanke, Mervyn King etc all had said before the subprime crisis that they would not intervene in financial markets. The outcome of financial decisions of various firms would have to be faced by respective firms. If they had stuck to their words, we would have called these policies as time consistent. Meaning your actions in future (not to intervene) were consistent with the policies made in the past.

However, they had to intervene and this made the policy time inconsistent. The financial markets knew all along the central bankers would be intervening as similar experiences had been seen in the past. The financial markets piled on huge risks knowing central banks and other authorities will have to intervene as health of financial system was important. This is exactly what moral hazard is and time consistent is another way to understand the approach.

The problem is not as much with current intervention but more with this time inconsistent policies with respect to financial sector. As a result, the risks get bigger with profits going to the firms and losses going to the taxpayers. This is leading to other issues like Too Big to Fail where a financial firm is bailed out as it is considered too big to fail.

Time consistency is as important a concept. The best way to follow it is to have some rules. That is why we have inflation targeting and even our FRBM act is a fine example of the idea. The problem is making rules to limit moral hazard in financial sector. How can we do it?

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4 Responses to “Time consistency is also a useful way to understand moral hazard”

  1. ezineaerticles » Blog Archive » Time consistency is also a useful way to understand moral hazard Says:

    […] Original Amol Agrawal […]

  2. Harikrishna R Says:

    Sir,

    Given that the Federal Reserve is explicitly tasked with preserving the stability of the financial system, I see no inconsistency whatever in it stepping in to prevent one or other important corner of the financial market from collapsing. I urge you to look for any one statement from Mr. Bernake explicitly saying that he would not do so. In both the supposed cases of “bail out”, Bear Stearn and more recently Freddie+Fannie, it is quite apparent that it was the system that was being bailed out.

    I am not arguing that there no consequence of Moral Hazard in the Fed’s (and now the American Treasury’s) actiond; only that time inconsistency does not really model what is going on here.

    Given the powerful forces on its side, one may safely bet that the financial system will not be “allowed to collapse” in a manner of speaking. This could hypothetically lead to behaviour where large players take on extremely risky bets since losing those bets impact not merely them but pretty much everyone else as well. They know that while they alone may be allowed to fail, the public will stand by them with the rest of the system. By linking the fate of the system as a whole to theirs, and using that link to as a basis of business policy, they abuse the public good faith.

    Perhaps the solution is to engineer a system inimical to large players.

  3. Club Lorem Ipsum :: La Ley de la Gravedad » Archivo » The efficiency of supranational governance III: The commitment value of international agreements Says:

    […] Secondly, even if we assume iron clad government, not vulnerable to pressure, governments have difficulties to commit themselves vis a vis firms when ex post and ex ante decisions are not equally beneficial. This is as old the Kydland Prescott paper on time inconsistency […]

  4. The efficiency of supranational governance III: The commitment value of international agreements Says:

    […] Secondly, even if we assume iron clad government, not vulnerable to pressure, governments have difficulties to commit themselves vis a vis firms when ex post and ex ante decisions are not equally beneficial. This is as old the Kydland Prescott paper on time inconsistency […]

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