What Is The Moral Hazard and Why Is It So Important?

What David Friedman talks about in his post that I reprinted here is essentially whats called the Moral Hazard.

Simply put, the moral hazard is when some party (an insurance company or finance company or whatever) engages in risky or reckless business practices because they don’t think they’ll have to deal with the negative outcomes of those bad practices.

How does it happen? When government gets involved in large-scale financial bail-outs of companies in certain sectors… the other companies in those sectors start to think that they’ll be bailed out eventually as well if they go bankrupt. They learn that they won’t have to deal with any negative consequences, so they can take on more risk that can give them more potential reward.

GSEs (Government sponsored entities) like Fannie Mae and Freddie Mac were backed by the government from the very beginning, so many economists argued that they would eventually fail due to the moral hazard principle. And so they did.