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Moral Hazard in America

An ideological battle has been going on in America – not the historical battle from the 1960s of communism versus capitalism – but, rather a battle between those who seek to sustain market fundamentalism as a credo, and those who believe that regulation of financial markets will help reduce the tendency toward moral hazard.  It has been argued by Joseph Stiglitz in his recent book Freefall (2009) that the excesses of deregulation led to the need for the Toxic Asset Relief Program (TARP) and other Federal bailouts after the sharp drop in the stock markets and freeze-up of the global credit markets in 2008/2009.  Further, he argues that programs like these and the “too big to fail” policy framework increased the tendency toward moral hazard, rather than reduced it.

Economists use the term “moral hazard” to indicate a situation in which one party in a transaction has more information than another leading to what is called “information asymmetry. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative 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.  In the US case, bankers, such as those involved in the recent Goldman Sachs controversy had more information, and clients and the general public, had less information.  So when Goldman Sachs began to hedge against the risk of market collapse and didn’t bring their trusted clients along, their actions demonstrated moral hazard.

Stock market boardThe actions of various parties during the sudden drop in the stock markets that are culpable all along the blame chain would seem to indicate moral hazard.  Each participant along the way in the mortgage lending crisis was acting in a rational manner but the highly deregulated framework did, indeed, give rise to moral hazard all along the way.   Taxpayers, now burdened with the ballooning debt from the various bailouts for banks and auto companies don’t necessarily connect the dots between the idea of deregulation, unemployment in the US, the widening of the gap between the very, very wealthy and the growing numbers of poor, cash-strapped state and local governments, and uncertainty about the future.  But these dots should be connected.

The actions of individuals in the US during the sub-prime mortgage market-induced world-wide recession have had global impacts. These actions were all rational at the time and were based on best information.  Individuals were all incentivized to ‘game’ the system to act in their own best interest.  The problem was that the policies were all devised within the context of market fundamentalist rhetoric which called for deregulation of the financial sector.

By combining the ideological framework of a deregulated financial sector with the high rates of consumption of American consumers in the 1990s and early 2000s and we had a disaster in the making.  Consumption was financed in large part from draws on the perceived (growing) value of assets (i.e., homes), and not from income.  Therefore, when the value of the assets went down, the bubble burst,  it left a lot of people underwater, not only on their homes, but also on their credit card debt.

But the vehicle upon which that easy money was based was induced by low interest rates (set by the Federal Reserve Bank, the herald of free market fundamentalism). It was exacerbated by more and more complex forms of securitization of subprime loans.  The loan originators had a financial incentive to generate more and more loans, which, in effect, became riskier and riskier. These loans were often Adjustable Rate Mortgages (ARMs) that had big balloon payments after a specified number of years.  Many of the borrowers could not make those payments and, therefore, had to walk away from their homes.  The banks had a financial incentive to securitize, or package, these loans and pass them on to investors.  Ratings agencies were also culpable in that their risk models did not include a way to characterize the synergistic effect of simultaneous failures in the financial system. In truth, there were many small moral hazards that all added up to one huge moral hazard for all of us.

All of the rational actors along that way were maximizing their benefit based on best available information.  The aggregate effect of this, especially in light of the budget cuts for education, health care, foreign aid and other socially desirable outcomes, has been to make the world a more impoverished, resource-depleted, and dangerous place to live.  One would think that, after the fallout from the failed policies of the market fundamentalists, that there would be little political support for continued efforts along those lines.  However, complex ideologies die hard.   We’ll all have to watch carefully how the debates on financial reform in Congress play out.   We have a moral obligation to do so.

6 Responses to Moral Hazard in America

  1. Chris Harding

    June 6, 2010 at 12:40 am


    Although I do not have experience with the finance industry, I find your article quite interesting. In addition, I have an opinion derived from watching and reading the news, working as a professional, reading the Economist, and considering the average mentality of many corporate employees. In my opinion, I believe the “moral hazard” is based on more than deregulation. If you don’t mind, I would like to use my regulatory experience as an example.

    From my experience as a pharmaceutical chemical engineer, FDA employee, and ex-employee of both, many corporate employees have an ethical problem. Personally, I believe second, third, fourth, nth generation corporate children have been taught ethical contructs that would be considered unethical in the public sphere. Why do I say this? As a first generation University graduate, I came from a US poverty-level family, which means my single mother was not even blue-collar. After accepting a position at a pharmaceutical company, I had a manager, who bragged about his “religion”, and told me I needed to take off my personal ethics hat and put on a corporate ethics hat. When I asked what he meant, he told me I needed to lie more. Hey, everyone lies, but I lie about little things and not about illegal or improper manufacturing that endangers lives of tens of thousands. On another occasion, a chemical engineering coworker in another division had manufacturing data errors, and I was the “verifier”. When I brought them to her attention, she said the FDA will never find them so just sign the data. I didn’t sign. I believe the coworker was at least a second generation corporate employee since her father was an engineer, and she often called him for advice. The manager sided with my coworker and said they could find someone who would do it. These people were doing illegal activity that was much worse than the latter. In fact, my manager often laughed as he endangered operators and technicians.

    As you know, an organization like the FDA is not truly equipped to “find data errors”, but this often occurs because corporations have created this as a “job function”. Rather, an FDA inspector is supposed to evaluate deviation and investigation reports of the “experts” and determine if the action and decisions were scientifically and technically sound. If, during that period, errors are discovered, the FDA assists with data verification. Since the legal data and legal process are proprietary, the process engineers and scientist are supposed to be the “experts”. When I began, I was told it takes, on-average, 4-6 months to become acquainted and knowledgeable. Since pharmaceutical companies have rejected FDA suggestions of placing FDA inspectors on the process, it is virtually impossible for an inspector to have the process knowledge of a Pharmaceutical company’s process engineer or process scientist. In my opinion, Pharmaceutical companies are aware of the latter, and I believe other regulated companies know this as well. Sadly, they are good at blaming the government, and government regulators can be called “political” if they discuss such activity. In truth, many government whistleblowers blow the “whistle” on activity related to corporations and face job loss and “harassment”.

    As you know, corporations have a tendency to fight regulations and the pharmaceutical industry is no different. In fact, some companies are employing pharmacists and using their State License to manufacture batches. Why? Because the FDA does not currently regulate compounding, several corporations have recognized this as a “loop hole”, and companies can bypass Quality System Regulations and FDA law-Supreme Court in Thompson V. Western States Medical Center, No. 01-344, April 29, 2002. In truth, the corporations decision to use this “loop hole” is based off monetary gain and quite dangerous because the dynamics of “scale-up” is quite complicated. As a matter of fact, many “drugs” have been scratched because scale-up failed to produce the same conversion. The “loop hole” was created after seven compounding pharmacies challenged the language of section 503A. Specifically, the compounding pharmacies argued the language violated commercial speech and the Supreme Court agreed. As a consequence, the entire section of 503A is now invalid.

    We have seen disasters with the chemical industry, food industry, financial industry, energy industry, and other industries. In my opinion, we are facing a monumental disaster in the medical device or pharmaceutical industry as well. Especially when you consider that 6,000,000 potential preparations can be made from one batch. As previously mentioned, I have witnessed illegal and dangerous manufacturing in US FDA regulated environments. When considering the latter along with the potential dangers associated with the compounding “loop hole”, I fear a potential future catastrophe. Sadly, people like myself are severely “harassed”, “black balled”, slandered, forced to endure a smear campaign, hacked, made to appear “crazy”, etc.

    Although I cannot understand how others become so involved in illegal activity, I have an idea. For some, considering mother and father as a criminal is uncomfortable, and others, who had a mother and father that engaged in “legal activity”, don’t want society to know of their unethical and illegal activity. I remember when I was hired and senior employees immediately asked if we had bought a house, a car, or had a child. Once the employee has a financial debt, they are asked to “scratch a buddies back” for sake of employment. Sooner or later, they have probably looked in a mirror, cried, asked why they are “so stupid since everyone else is doing it and the senior coworkers wouldn’t really endanger the lives of others”, and decided to sign the data. I experienced all but didn’t sign or engage in illegal or unethical activity, and I have payed the price professionally, and I earned three Vice-President’s Awards and optimized my area of a process. On the other hand, I know I am not responsible for a death that may be related to an improperly manufactured drug. Sadly, many doctors or pharmacists may not associate the allergic reaction to improper manufacturing.

    When considering the “housing bubble”, I believe the “wealthy” and “informed” knew exactly what was happening. Did they jump from the internet bubble to the housing bubble? Interestingly, Mr .Warren Buffet disliked both! As we know, corporations value productivity, which means the American worker produces more, works more hours, and this means there is a reduction of American workers in corporate America. Often, it is bragged that an American worker produces the same as two in the past. In reality, the productive worker isn’t payed much more and the corporation absorbs the profits. In most instances the “bonus” is distributed among the managers. Although beneficial, it means there were fewer workers to buy all those houses. Is it possible that some took advantage of American productivity? How? Many contractors, real estate developers, and relators were told there was plenty of “free cash” in the economy. In truth, the cash was mostly distributed among the top, and few were interested with buying multiple houses in the same community. While living in Southern Wisconsin, I noticed all the new houses, realized the fairly constant employee numbers among corporations, and kept asking the following question. Where are the people who can buy these houses? Even if new “small businesses” are considered, which isn’t logical, there is usually a five to seven year period of likely failure. As such, banks and business owners would likely be considered negligent.

    As I have previously mentioned, I have endured a horrific form of “harassment”. In truth, I do not consider the activity as harassment and believe this word is actually used to describe murderous activity. Why? I have had people attempt to run me over on my bike, threaten my life, threaten my families lives, and tell me I should commit suicide if I don’t want to endure. In the past, I thought the activity was due to my ex-manager, his coworkers, their friends, and “network laundering”. Recently, the corporation admitted and “emphasized” that “harassment” does occur, and this admission occurred after I supplied specifics. Interestingly, similar activity has occurred since I left the company in 2001, but it was not admitted until this year. The “perpetrators” threatened my nieces life in 2007, and I reported this to the police in 2007 as well. In 2009, she was side swiped by a hit and run driver and spent time in the hospital. Afterwards, strangers “emphasized” that she had not died. Why does this occur? Corruption and “organized crime”. Although corporations do not murder, people do murder. As the Berkley document states, one way to end corruption is to discuss it openly. As a victim, this is now a forced passion!

    If I do not get accepted into a pharmacy program, I plan on returning to college, earning a degree in ethics, seek a PhD, and research the ethical constructs of corporate America. Although a monumental task, I would like to fight the “harassment”, assist with enforcing OSHA laws, hold white collar managers, scientist, and supervisors responsible for worker homicide, and speak about reducing “negative activity” by “positive discussion” and removing the “negativity barrier”. As a pharmacist, I will do something similar but from the perspective of a pharmacist.

    Finally, have you seen the PBS special on Trade secrets? If you don’t mind, I would like to provide a link to the latter, some FDA links of Pharmacy Compounding, a reference to Dr. Rosner’s journal article, “When are workers deaths considered homicide?”, a New York Times article on United States lack of prosecution of negligence and workers death, and a reference to the Berkley Law Document:

    A lawsuit against chemical companies:

    • Public Broadcasting System. Trade Secrets, A Moyers Report. OPB[online]. 2010. Available from: Trade Secrets. Search: PBS.

    A “loop hole” in Pharmaceutical Manufacturing:

    • United States Food and Drug Administration, “FDA”. Compliance Policy Guide. Compliance Policy Guidance for FDA Staff and Industry. Pharmacy Compounding, Chapter 4, Subchapter 460. FDA[online]. 2010. Available from: Section 460.200, Pharmacy Compounding. Search FDA: US FDA.

    Drugs. 2006 Limited FDA Survey of Compounded Drug Products; Includes description of quality problems and female hormone products, inhalation products, and local anesthetic products were sampled and evaluated:

    • United States Food and Drug Administration, “FDA”. Drugs. 2006 Limited FDA Survey of Compounded Drug Products. FDA[online]. 2010. Available from: Guidance, Compliance & Regulatory Information, Pharmacy Compounding. Search FDA: US FDA.

    When Does a Worker’s Death Become Murder?

    • Rosner, David, PhD. Am J Public Health. When Does a Worker’s Death Become Murder?. American Journal of Public Health[online]. 2000. vol. 90. pp. 535-540. Available from: Am J Public Health. American Journal of Public Health: Search. Search: Entrez, The Life Sciences Search Engine.

    A New York Times article on negligence, OHSA, and workers death:

    Barstow, David. The New York Times. National. U.S. Rarely Seeks Charges for Deaths in Workplace. New York Times[online]. 2003. Available from: Article.

    A Berkley Law and International Relations Document on corruption, organized crime, and policy suggestions. A study of 66 Nations:

    Buscaglia, Edgardo, & van Dijk, Jan. (2005). UC Berkley: Berkley Program in Law and Economics. Controlling Organized Crime and Corruption in the Public Sector. University of California eScholarship[online]. Jan. 2005. Available from: eScholarship. University of California About the New eScholarship

    • Jane Ginn

      June 8, 2010 at 1:17 am

      Chris – Thank you for these well-considered and well-researched reflections. It sounds to me like you have been evaluating this issue at a very deep level for some time. I am currently traveling in the Middle East and have continued to reflect on the implications of moral hazard as it plays itself out in the international arena. More on that later….. I look forward to additional comments from you on more of our articles.

      • Chris Harding

        June 8, 2010 at 10:16 am

        Mrs. Ginn,

        First, I hope you are having a nice day. If not, I hope it gets better soon!

        Next, I would like to thank you for posting my comment. I discovered your informative site after you shared my Conversations for a Better World article on Oral Contraceptives.

        Finally, in my opinion, your background suggests that you have been trained in mediation and conflict resolution, but I thought I would share the following journal article since you are in the Middle East. To me, the article, which is titled “Conflict resolution in a different culture” seems to discuss the authors experience with Saudi culture more than “negotiation” but I would assume an understanding of culture is an important part. In addition, the article discusses the hospital environment. Still, you may find it interesting and useful. I reference the article in a fun post at my Gather Network as well, and mention a potential error. As a chemical engineering student, I had friends from Saudi, Kuwait, Jordan, etc. and I also served in the Gulf War. Therefore, I believed a statement was potentially inaccurate but I could be wrong. Although I have not read the following links, they are available as a “reference” in the above mentioned article.

        • Irani GE. Islamic mediation techniques for Middle East conflicts Available at http://www.mediate.com/articles/mideast.cfm; accessed April 6, 2008.

        • LeBaron M. Culture-based negotiation styles University of Colorado, Boulder: Conflict Research Consortium, July 2003. Available at http://beyondin-tractability.org/essay/culture_negotiation/; accessed April 6, 2008.

        Conflict resolution in a different culture:

        • Winter, David F., Jr, MD, MSc; Chevrier, Marie Iabelle, PhD. Conflict resolution in a different culture. Proc (Bayl Univ Med Cent).2008.Vol.21(3), pp.300-303. Available from: Entrez, The Life Sciences Search Engine. Search Entrez. PMCID: PMC2446421.

        My Gather Network Article:

        • Harding, Chris, “QuidnuncSimcha” or “Quidnunc Simcha”. Gather.com. Chris H. Gather Network. Gather[online]. Culture, Religion, Dress, and the Belgium Law. 2010. Available from: Gather Post My GatherNetwork.

        Have a nice night!

  2. Stephen Reiss

    May 10, 2010 at 10:22 am

    Thanks for the response.

    The meticulous accuracy and detail of your response illustrates the problem with the debate you referred to in you post – it is specious at best. There is no real conflict or debate where both sides are arguing for some version of interventionalism; where both sides accept the greatest antithesis of a free market economy – the Federal Reserve.

    As you showed, the Federal Reserve was a key cause of the housing bubble. The Federal Reserve, the engine of monetary inflation, lies at the heart of every boom and bust; phenomenon that only occur as the result of government action and not as the result of any inherent feature of a true market economy.

    The debate in the mainstream media rarely refers to the only true free market school of economics – the Austrian school. The Chicago boys offer an easy target, while the Austrian school is bullet proof with an unparalleled record of accuracy for more than a century.

  3. Jane Ginn

    May 9, 2010 at 10:13 am

    There are many examples of how the Federal Reserve, especially under Greenspan and now under Bernanke, have acted in a manner consistent with Chicago School economics or “market fundamentalism” as many are calling it. One of the four main pillars of the Fed’s authority is:

    “Maintaining stability of the financial system and containing systemic risk that may arise in financial markets.”

    In the build-up to the current global economic crisis that was seeded by the U.S. sub-prime lending market and blossomed fully with the failure of Lehman Brothers on September 15, 2008, the role of the Fed was key. It had both encouraged excessive risk taking by many in the financial sector as a result of its tight control of interest rates from 2000 through 2005, and it intervened directly to advocate the idea that markets are self correcting.

    A specific example of this direct control is the position that Greenspan, Levitt and Rubin took on May 7, 1998 in the early stages of the development of Credit Default Swaps (CDSs), now known to be one of the instruments that were used in the build up of the U.S. housing bubble. At that time the Commodity Futures Trading Commission (CFTC) became concerned that CDSs were traded over the counter and not on established exchanges. They were concerned about the regulatory void in these and other derivatives. On May 7 Greenspan et al. testified before Congress about the content of a set of proposed rules of the CFTC that would have brought this trading activity under the purview of the established exchanges. The argument was that markets are self correcting. Ultimately the Senate Agricultural Committee strong-armed the CFTC and got them to back down. Shortly after that Long-Term Capital Management was rescued by the U.S. government (at great expense to the taxpayers)….but, that was just the tip of the iceberg and the precursor to what happened in 2008/2009….and from which the global economy is still seeking to recover.

  4. Stephen Reiss

    May 4, 2010 at 9:37 am

    What do you mean when you say the Federal Reserve is “The herald of free market fundamentalism”?