Moral Hazards

One of my childhood responsibilities with money earned on after-school and weekend jobs was to pay for my school lunches. It didn't always work out that way. I regularly squandered money on weekend fun, and come Tuesday or Wednesday I'd go to Mom seeking a school lunch bailout. One time Mom lectured, "You knew you needed money for lunch when you spent it. No, I'm not giving you money!" I thought Mom was the cruelest woman on the face of the Earth. I had no idea that she was coping with what's known as the "moral hazard" problem.

Moral hazard arises when people behave in ways to satisfy themselves, but because they don't bear the full cost, their behavior comes at the detriment of others. Moral hazard is a pervasive problem and it's only relatively recently that economic and legal scholars have begun to pay attention to it. For example, if the contents of my car are fully insured against theft, I will be less diligent in locking it up and taking other precautions against theft. I might even make false theft claims. That's a problem for insurance companies. They can't tell whether the theft was a random insurable event, or something readily avoidable with reasonable precautions, or fraud. Auto insurance companies cope with this problem, and not that effectively, by writing policies with high deductibles thereby requiring me to pay, say, the first $1,000 of a loss.

Government programs like Social Security and Medicare create moral hazard problems. If people know they can squander their earnings during their younger years and still receive income and health care in their older years, then why make sacrifices in order to save? Other taxpayers, not them, bear the consequences of their short-sighted behavior. Plus, if senior citizen handouts are guaranteed, why go through unpleasantries of instilling in children the values and responsibility of taking care of an elderly parent in need?

Today, when there's an illegitimate birth, it is possible that neither the mother, the father, nor the families will bear the full consequences of the irresponsible behavior because there's welfare, food stamps and other handout programs. Since the cost of the couple's behavior can be shifted to taxpayers, we shouldn't be surprised to see more irresponsible behavior. Costs have been lowered in another way; today there's little or no social stigma to illegitimacy.

CEOs being managers of other people's money, rather than their own, don't bear the full consequences of unwise decisions as would a company owner. One stockholder strategy to fight the moral hazard problem, and encourage CEOs to behave as owners, is to make company stock a large part of their compensation.

It would be great if we could somehow do something similar with politicians. They too are managers of other people's money and don't bear the full consequences of unwise decisions. The best time to waste money and be "compassionate" is when it's with other people's money. I can't think of any way to address the political moral hazard problem other than by trying to keep more of our money in our own pockets and out of theirs.

Getting back to Mom's approach to the moral hazard problem - today's touchy-feely society would see Mom as a cruel person and might charge her with child abuse. After all what kind of parent could stand to watch a growing kid come home starved and virtually inhale the refrigerator. To see me hungry couldn't have been any more pleasant for Mom than it was for me. But the bottom line is that I never squandered lunch money again. Long run compassion sometimes requires short run toughness.

Walter E. Williams


March 22, 1999

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