First we heard about ‘sub-prime mortgages’; then it was ‘collateralised debt obligations’; now it’s the turn of ‘moral hazard’ to appear on the Ten O’Clock News.
Jolted out of prosperous complacency by market turmoil, the public has started to care about economics: strange jargon and obscure concepts previously familiar only to investment bankers are going mainstream.
The best way to understand moral hazard is to reflect on how taking out insurance changes our behaviour, encouraging us to take greater risks and less care of our possessions. A holidaymaker without travel insurance is more likely to keep an eye on his baggage than one who can claim compensation if it’s lost or stolen. The threat of moral hazard is in fact a central concept in modern life.
Thus if bank deposits are always protected by the state, depositors will cease bothering to check on the creditworthiness of banks and will simply choose the highest-yielding account, regardless of whether or not the institution in question can actually afford the deals it offers.
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