My wife needs a new passport. So the other day, we got the form and filled it in. The Post Office offers a service where they’ll check your application to make sure you haven’t made any mistakes – which we thought would be worth paying a bit extra for, as we needed it back in a hurry. So we were a bit put out when she later got a call from the passport office. She’d forgotten to put in our wedding certificate, which needless to say, our man at the Post Office hadn’t noticed.
Why am I telling you this? Because I think it’s a good illustration of what lies behind today’s whole financial crisis: moral hazard. This is basically the idea that if you believe you are protected from the consequences of your actions, you’ll be less careful. Sure, you can argue that if the guy at the Post Office had done his job properly, he’d have noticed the certificate was missing before he sent it. However, if the Post Office hadn’t offered the service at all, then we’d probably have completed the application correctly ourselves in the first place.
“When governments strip out risk, people get careless”
Something similar happened during the financial boom. Take the fraud cases now coming to light. The claims about investment returns made by both Sir Allen Stanford and Bernie Madoff, for example, never really stood up to scrutiny. In fact, the US regulator, the Securities and Exchange Commission (SEC), was warned years ago by whistleblower Harry Markpolos that Madoff was running a Ponzi scheme. Yet nothing happened until the end of the boom meant Madoff’s scam couldn’t go on.
Certainly, you can blame the SEC. After all, it wasn’t a lack of rules that led to these frauds going unnoticed – the regulator had all the powers it needed, it just didn’t use them. But really, investors’ own due diligence should have unveiled at least a whiff of something rotten about the miraculous returns on offer. Instead, they were just having fun in the apparently risk-free investors’ playground created by central bankers and light-touch regulation.
As some of our Roundtable experts point out this week, that’s why it’s so depressing that many people blame this blow-up on capitalism. Capitalism depends on risk being properly rewarded when entrepreneurs get it right – and punished when they get it wrong. When governments try to strip the risk out by regulating it away, or by flooding the market with cheap money every time something ‘bad’ happens, people just get careless. They believe that house prices can rise forever, or markets will always be bailed out, or that smooth-talking crooks promising never-ending, double-digit returns are telling the truth. But risk has a habit of re-asserting itself in the end – as investors with Mr Stanford are now learning to their cost.