The Fed and the Moral Hazard Problem - The American Spectator | USA News and Politics
The Fed and the Moral Hazard Problem

Quin, it seems like what you’re basically saying is that the Fed should cut rates to avoid a credit crunch while still asserting a commitment to fighting inflation. The problem I see is that such a policy would create, in economic terms, a moral hazard. Here’s what I mean. I remember covering the subprime mortgage industry during the housing boom back in my days as a financial reporter. At the time, with rates at the lowest levels since the Eisenhower era, lenders were giving away mortgages like candy, and were rewarded with stratospheric profit growth and surging stock prices. The problem, however, was that in their push to maintain staggering growth rates, standards went down, and they kept loosening their credit criteria. So, it should come as no surprise that they are now being forced to pay for their unwise lending decisions. Perhaps the credit market is overacting and being too tight now, but I think that this is a process that needs to work itself out, and I think that lenders need to suffer consequences for poor lending decisions so that hopefully they can learn something from this experience and behave more rationally in the future. If the Fed were to essentially set the precedent that it would always cut rates to bail out lenders who have made poor lending decisions, it will only encourage future lenders to make similarly risky decisions down the road. Japan, in a much more dramatic way, faced all sorts of problems because its government would not let banks fail, and thus encouraged them to engage in risky behavior. I think it’s important to examine the long-term implications of what you’re proposing.

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