I saw a segment on the PBS news hour that tried to blame the troubles with Fannie Mae and Freddie Mac on moral hazard. This is, of course, nonsense. Moreover, it's a pretty good rule of thumb to recognize that any time anyone argues anything on the need to avoid moral hazard they're up to no good and trying to pull a fast one on you. Most commonly this boils down to the argument that the government shouldn't insure anyone against any risks because doing so lets people be less vigilant against those risks. You can only say that if you believe that all risks are volitional, or if you're rich enough to self-insure and don't give a hoot about anyone who isn't.

Moral hazard is a hypothetical state that serves as a practical limit in the writing of insurance. It occurs when the insured value exceeds actual value by so much that the beneficiary is tempted to cash in by destroying the asset. For instance, if you have a house insured for $800,000, but the house is termite food and water damaged and home to a family of skunks, it might occur to you that you'd be better off if the house mysteriously burned down so you could collect the insurance. In other words, the deal is set up in such a way that it gives you an incentive to drop your moral sense.

That sort of thing makes sense in theory, which is why it often makes an effective argument, but in practice it's pretty easy to avoid such situations. For starters, almost everything that you can buy insurance for errs on the side of leaving you underinsured: the insurance reduces your pain, but it doesn't eliminate it, let alone reward it. Secondly, most of what you can deliberately do to trigger a claim is illegal, including the wide range of deceptions known as fraud. (The example above is at least fraudulent, even if the house burns down due to negligence and not arson.) Insurance companies can also limit their exposure by inspecting and regulating their risks, either directly or through other agencies (e.g., airline insurers can assume that the FAA is inspecting and regulating airliners).

The point here is that moral hazard isn't something that undermines the whole insurance industry. It is an easily managed technical issue. Moral hazard can only appear as a plausible explanation in cases where insurer discipline has broken down. The Savings and Loan crisis in the late 1980s is commonly given as an example, but that was really a case where deregulation and lack of oversight and exposure enabled bankers to assume more risk than was prudent -- especially given that their willingness to trade paper profits for risk was so prone to fraud. Still, it's hard to credit that deposit insurance made bankers any more likely to make risky loans. Bankers are always more concerned with their assets and profits, which is what they gambled with and lost on, than with their deposits.

Even after the PBS report I can't tell you what moral hazard might have had to do with Fannie Mae and Freddie Mac. The story there is that Congress, back when privatization was coming into vogue, took a couple of perfectly functional government agencies and turned them into Government Sponsored Enterprises. In a nutshell, that meant that investors and management could scam them for profits while liabilities would still fall back onto the government. As government agencies all they had to do was to provide the public with services as efficiently as possible. As private companies, their management's mission changed: now it was to extract profits for their investors (who in turn lavishly rewarded management). The result was the predictable hollowing out of business that has been occurring in virtually every sector of the US economy since the 1970s when we started shifting our focus from goods and services to finance. (Kevin Phillips has a lot to say about this.) Basically, they got away with it as long as real estate appreciated, and got caught up short when the real estate bubble burst. (Same event sequence as the S&L's.)

Fannie Mae/Freddie Mac won't be a disaster because the government is there to pick up the pieces and keep mortgage finance running. But the one thing this shows is that the privatization vogue didn't amount to anything useful. Fannie Mae and Freddie Mac could have functioned at least as well, with a lot less scandal, as government agencies. One interesting thing that's coming out of the current financial meltdown is how much space is opening up between the conservative ideologues of pundit-world and that the conservative bankers who are running the system. You don't hear the latter talking about moral hazard and how the markets will correct themselves if only you allow them to fail when the time comes. Rather, they are straining to hold the system together and save us from even worse collapse, and mostly making prudent and reasonable moves along the way. I'm not prepared to go so far as to argue that the Bush administration has switched over to the side of sanity, but there is at least some of that going on now, and it makes the far-right punditocracy look even dumber than ever. (Cf. John Bolton on Iran for an unrelated case in point.)