Mises Wire

What’s So Moral About Moral Hazard?


Most economic concepts never make it out of the academic journals, let alone into the public eye and public opinion. The concept of “moral hazard” is a rare exception: largely due to the financial crisis, this once-technocratic insurance term has become almost a household word.

This is all to the good, because moral hazard is a great example of how powerful basic economic reasoning can be. In particular, it offers a simple way to express some of the key advantages of markets, as well as some key problems of government intervention.

But what is moral hazard, exactly? Like most economic terms, the definition varies depending on who you ask. However, the most useful approach is suggested by Guido Hülsmann in an important paper titled, “The Political Economy of Moral Hazard.” In Hülsmann’s view, moral hazard is

the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes to know, that someone else B will provide some or all of these resources. The important point is that this occurs against B’s will and that B is unable to sanction this expropriation immediately. (Hülsmann, 2006; emphasis in original)

Moral hazard is a prime example of common-sense economics at work. Being able to impose the costs of your action on others, without their direct consent, provides a powerful incentive to act in ways you normally wouldn’t. A classic case of moral hazard is fire insurance, which reduces the incentive for insured people to avoid fire by imposing certain costs on the insurance company.

Unfortunately, mainstream economists often use the logic of moral hazard to argue for the existence of market failure, and for the provision of public goods. They usually overlook the fact that government itself is the most important institutionalized moral hazard in society.

Lately though, talk of moral hazard tends to be associated less with market failure, and more with government failure. In the wake of the financial crisis, for example, millions of people realized the moral hazards at work in public policy. It doesn’t take extensive economic training to see that government bailouts and too-big-to-fail policies for banks and financial institutions are disastrous, especially because they encourage the very behavior they’re supposed to prevent.

Despite its seemingly straightforward implications, however, moral hazard has always been a contested concept in economics, and also in ethics. In particular, some scholars argue that moral hazard is not a scientific concept at all, but rather a thinly-veiled moral judgment.

According to this view, ever since the term “moral hazard” was coined in the 19th century, it‘s been a tool of insurance companies and economists, who’ve twisted it to serve their own interests at the expense of the public. These people want to reduce public benefits, and they use the seemingly-scientific language of moral hazard as an excuse to do so. When insurers and economists talk about moral hazard problems, they’re actually trying to discredit disadvantaged people by questioning their motives. To take one example, private interests insist that the poor can’t be trusted to take only reasonable risks, because they are morally flawed. Their weak character in turn means that, for instance, they’ll over-exploit health insurance and simply push the costs onto the rest of society. Bad character thus leads to economic inefficiency. According to the critics, the case against public health care is based on this kind of reasoning.

In fact, for the critics, moral hazard is little more than an unjustified character judgment used to promote an austerity agenda. It therefore lacks scientific merit. (For some examples of this type of criticism, see here, here, and here; the title for this post is adapted from the third source.)

Like many criticisms of economics, this one is most dangerous because there’s a grain of truth in it. It is true, for example, that the concept of moral hazard has a chequered past. The term was coined in the insurance industry, and often did reflect unjustified judgments about the character of insurance claimants, especially the poor. And even today in economics the term is used in different and ambiguous ways, some of which imply the immorality of consumers.

However, these historical facts fail to undermine the basic logic of moral hazard. Moral hazards, including moral hazards created by government, have little or nothing to do with the character of the people involved, whether they are politicians or just people looking for health insurance.

It’s possible to talk about human value and choice without resorting to judgments about individuals and their moral fiber. In fact, this is one reason economics is such a powerful tool for analysing the world: its conclusions are valid no matter what values and motivations people ultimately hold.

We should remember that when we talk about incentive problems, we’re really just speaking about human choice. Incentives don’t force us to do anything: they’re just the value attached to a particular action. If people think the costs and benefits of action are changing, they’ll often respond by making different choices. This simple logic provides a basis for much of economics, including the idea of moral hazard.

Of course, economists can be too dramatic about the role of incentives, and they do sometimes use the concept to smuggle in their own value judgments (see also here). But that doesn’t change the basic fact that people choose based on their expectations about the costs and benefits of action. When the costs can be reduced by shifting them to others without their direct consent, we shouldn’t be surprised to see people act differently. The bottom line is that markets make it difficult to shift these costs without permission, while governments make it inevitable.

There’s much more that could be said about the economic and moral problems surrounding moral hazard (see here). But we need to emphasize that it is still a vital concept for economics. We should therefore be careful not to let critics trivialize or dismiss it; when they do, calls for government intervention and special privileges are seldom far behind.

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