Moral Hazard, expanded

Those who know me, know that moral hazard is, to me, the most important concept in economics, particularly because of its spillover into ethics and morality. My problem with the economics profession as a whole, is that its members tend to use an extremely narrow definition of the term, hobbling its significance and importance. I'd like to change that.

How do most people define the term? Let's look to Wikipedia first:

In economics, moral hazard occurs when one person takes more risks because someone else bears the cost of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place. 

Moral hazard occurs under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information. 

Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

It might also help to know what "information asymmetry" is:

In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.

The definition is thus limited to cases of "taking risks" you wouldn't otherwise take, because someone else is "bearing the costs." Somehow this seems incomplete to me. Why just this one behavior, and not any other actions you might have taken when you realize (or believe) you yourself are not fully bearing (or not bearing at all) the burdens involved, because of the particular structure of incentives? It turns out, every action you take entails unique risks. There is no distinction between incentives to take alternate actions and incentives to take alternate risks. Every incentive does both.

In the Milgram Experiment, everyday people were subjected to perverse incentives, and actively victimized others (or in this case, carried this illusion -- nobody was actually hurt; it was acted) as a result. An authority figure absolved them from any responsibility for their actions, so most of the test subjects complied, to one degree or another (Link to: Milgram experiment on Wikipedia). Is directly imposing burdens (pain, injury, impeding others, etc.) upon others a form of moral hazard (especially if someone is explicitly absolved from responsibility for the effects of these violent actions)? This seems to follow the form and spirit of the term, so I would say "yes."

Moving to "information asymmetry," we are talking about a situation where one person knows more than another person regarding the particulars of a mutual arrangement. What is it called when you don't know something, or don't fully understand something? Ah yes, ignorance! If your ignorance causes you to believe in a different set of incentives (and apparent burdens) than actually exist, this would encourage you to act differently than you might otherwise act, wouldn't it? If you are aware of someone else's ignorance, isn't that also an incentive to act in ways you might not otherwise act, in regards to that person? Doesn't this also fit the form of the term "moral hazard"? I think "yes" to this as well.

Getting to the conclusion, moral hazard describes any situation whereby the burdens of an action are either not fully borne by the person acting, or the person ignorantly believes this to be the case. Now, this has far-reaching implications in other fields of study, which I intend to touch upon in future blogs. Stay tuned, and in the meantime, think about it.

On the Demise of Empires

Imperialism is a fascinating social phenomenon. We see it arise in every nation which develops a comparative advantage relative to a significant proportion of other nations. It also seems to have the tendency of arising more quickly among relatively wealthy nations. The reason for this is obvious: the more wealthy the host the more healthy its parasitical instrument of large scale conquest can be. People are drawn to power and prestige, and in conquest and slaughter many of us find it.

We see imperialism not only among nation-states, but within them. Imperialism within a modern nation-state takes the form of the democratic process. Differing factions war among themselves by means of the ballot, sacrificing ever more of their own power over their own lives in exchange for power over the lives of others. But what they don't know is this is akin to a bargain with a devil, where they will be fed upon by those who appeal to them with their empty platitudes.

Where once relatively wise and free people became rich, all too quickly do their descendants become proud, self entitled, and eventually poor. The imperialism feeds upon itself. The spoils of conquest can never make any society rich in the long term, because destruction is not production. It's really that simple. Those who enrich themselves at the cost of others by means of the state do not create anything, they only cease from coming into being those things that would have been created by others.

All societies that succumb to imperialism consume themselves. But it seems as though prosperity breeds imperialism. Empire is thus its own demise.

Commerce and Corruption

If you follow New York State political news, then you know that corruption scandals have played a big role in both party politics and in election news. So-called "ethics reform" has been a big talking point over the past year or so, with people pointing fingers at the Dean Skelos and Sheldon Silver convictions. Both men took money for favors, and used their discretion in their respective positions, to force certain outcomes each man considered personally advantageous. "Get the money out of politics" has become an election year mantra once again, the underlying assumption being that commerce skews political power and undermines the noble intent of these otherwise noble people. I call bullshit on this.

The cycle has to start somewhere, and it seems pretty obvious to me that it starts in the edifice of state power. The rules are laid out: Bureaucrat position A is allowed to exercise specific duties (i.e. activities otherwise considered criminal, belligerent, manipulative, or simple bullying if they are performed privately) within a certain range of discretion. Relatively speaking, these rules are pretty rigid and unforgiving, and these duties and methods are fairly specific. The process becomes ossified and archaic, slowing down or halting entrepreneurial action, creating a well-lit roadblock to commerce. Enter the bribe.

In response to these rules, clever individuals figure out where the roadblocks are, and find ways to circumvent or bypass them, enlisting the aid of the gatekeeper bureaucrat to "look the other way," or "grease the wheels" to "get things done." In exchange, the bureaucrat is compensated commensurate with his ability to make the rules more binding or less binding to particular parties. Deals are made in secret, while the official line is "bribery is illegal and wrong!" Keeping such activities illegal creates barriers to entry for all but the most politically connected and wealthy, and the bureaucrat can tailor his services around a small list of particular clients, charging high margins for the privilege.

The government bureaucrat is not noble, but is most certainly human. Market activities find ways to close the doors on moral hazard, and create beacons as big as life, allowing people to scrutinize the otherwise opaque wall erected through legislation, between the political class and the private class. Without commerce (bribery), the bureaucrat is absolute in his domain of power and discretion; with commerce, there is at least some wiggle room for some of us, and the bureaucrat must cater to his customer base. Power corrupts commerce, not the other way around. If not for the well-lit roadblocks, individuals would be spending their money in other areas, rather than lining the pockets of the politicians.

If you really want to close the doors on corruption, you need more commerce, not less. Legalizing bribery forces a bureaucrat's margins down, and broadens the base of people he will need to cater to in order to continue to enjoy his earnings. Along the way, the roadblocks do not just become clearly visible, but they become invasive and palpable, naturally calling into question the legitimacy of the political power in question. Public outcry does the rest, the shackles come off, the bureaucracy becomes smaller, and life gets better. Think about it...