Moral hazard is something that comes into spotlight every few decades when the importance of a central banks becomes a topic of discussion.  Moral hazard is by definition what happens when people act differently because they’re insulated from risk.  Now as the credit crunch wanes on and hundreds of banks are on the brink of collapse, moral hazard is being brought up once again.

In a normal market, people would make decisions based on what they would consider a risk to reward ratio.  When the government subsidizes or insures banks and other institutions from loss through bailouts and FDIC insurance, moral hazard is created.  The banks can take an unlimited amount of risk without any chance of loss.  If problems occur then the taxpayer pays for the bailout.

Moral hazard also creates circumstances where the profits from businesses are privatized but the losses are socialized.  The possibilities are that corporations prosper before the odds catch up to them and then the losses are spread out amongst thousands of taxpayers.  The trouble is, plenty of moral hazard is in play today but still well outside the banking industry.

The US government heavily subsidizes ethanol at a rate of $1.45 per gallon.  Without this government subsidy, it is unlikely that as much ethanol would be produced.   The moral hazard of ethanol production works just the same as moral hazard in the banking industry.  Government intervention required to force moral hazard affects any market: this time around we’re afraid that Fed bailouts create moral hazard in the banking industry.

The importance of bailouts is something that has been sold to the American public as something that is a part of the natural business cycle.  The most natural though would be to let these corporations heavily insolvent to fail on their own.  The banks have to be forced to hold down their own risks and accept responsibility for the losses.