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The Moral Hazard of Central Banking

Cristian Gherasim

Virtually all economists agree on the proximate cause of the current financial world crisis: institutionalized moral hazard in the financial industries. Banks and other firms operating as financial intermediaries have a tendency to behave irresponsibly. They display an exuberant bias in their investment decisions, often taking risks out of proportion with possible returns on investment. Most notably they have reduced their equity ratios to extremely low levels, typically to less than ten percent. Equity being the economic buffer for losses, it follows that financial firms are more vulnerable the smaller their equity ratio. If such vulnerable firms dominate the market, there is an increased likelihood of contagion, as the liabilities of any one firm are usually the assets of other financial firms. The bankruptcy of just one sufficiently large firm can then trigger a domino effect of subsequent bankruptcies. The entire financial market melts down.

While economists agree on this basic fact, they disagree about its causes and remedies. Some seem to believe that the bias toward irresponsible investment decisions is a fact of nature such as bad weather and death. Financial markets are unstable by their very nature because the agents on these markets profit from superior knowledge as compared to their customers and therefore can enrich themselves at the expense of the latter.

While this theory is very widespread, it lacks any foundation in fact. If financial agents really had a bias to rip off their customers, there would soon be no clientele for them. Common people might be less informed than their bankers about the technicalities of financial instruments and investment strategies, but they can read a bottom line. They can also compare bottom lines and abandon their agent if they feel other people might take better care of their money.

The true cause of moral hazard in the financial sector is to be seen elsewhere, namely, in monetary policy and especially in the current monetary system.

Central banks function as lenders of last resort, that is, they lend money to financial firms and others who are unable to find creditors on the market. The salient point is that they can provide this service without any technical or economic limitations. Indeed, the money they lend does not cost them anything at all. Central banks do not have to borrow money; rather they make the money of the nation. Because paper notes are virtually costless to make, it follows that the amount central banks can lend is basically unlimited. This allows them not only to provide virtually unlimited credit to governments and similar institutions, but also to bail out market participants on the verge of bankruptcy. Thus they can prevent financial contagions and meltdowns.

At first sight, it appears that the activity of central banks is wholly beneficial. However, the exact opposite is the case. The problem is that the financial firms know that the central banks are there to help them out in times of trouble. They know that these institutions can make and lend as much money as they wish, at any price they wish, without being subject to physical or economic constraints. As a consequence, financial agents have the incentive to reckon with this kind of assistance. Rather than making their business plans and investment decisions in a responsible way, relying on other people only through contracts and other voluntary agreements, they now rely on publicly sponsored bailouts.

Who pays for such bailouts? Not the customers of the banks and other financial agents. Rather, these groups belong to the net beneficiaries of this policy. The true paymasters are citizens as a whole, in their capacity as money users. Bailouts through monetary policy always involve increases in the money supply.  Money prices then tend to increase beyond the level they would otherwise have reached, and thus the purchasing power per unit of money is diminished below the level it would otherwise have reached. The real cash balances in the pockets of the citizens shrink, as do the real incomes of all people. Of course financial agents and their customers share this kind of loss, because they too are money users. But they pay only a part of the total bill. The rest is imposed on the rest of society.

To sum up, bailouts through monetary policy socialize the costs of bad investment decisions. This creates a moral hazard on the side of all the beneficiaries. Financial agents can worry less about risk and concentrate on possible profits. They become exuberant and turn to excessively risky business practices. But their customers are prone to moral hazard too. They realize that money invested on the financial markets benefits from central-bank support. Therefore they have a perverse incentive not to look too closely at the risks. They become exuberant as well.

Financial market fragility and moral hazard are therefore only proximate causes of financial crises. The ultimate cause is monetary policy, and in particular, the current paper-money system, which allows the central banks to provide limitless lender services. Monetary policy creates powerful incentives for market participants to reduce their equity ratios and thus increase the likelihood of contagion. The lower the average equity ratio, the smaller is the critical firm size that might entail contagion effects.

The foregoing considerations are perfectly straightforward. They are a hard pill to swallow, though, for true believers in the benefits of paper money and monetary policy.


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