Robert Reich: The Moral Hazard Double Standard

Robert Reich tells us that despite the talk about moral hazard, the rich have plenty of safety nets:

The real moral hazard in this saga started when Fed Chair Ben Bernanke cut the Fed’s discount rate (charged on direct federal loans to banks) and announced that the Fed would take whatever action was needed to “promote the orderly financing of markets.” Translated, this means that lenders, credit-rating agencies, financial intermediaries, and hedge funds will be bailed out, one way or another, because they’re simply too big to fail. Note that behind every one of these institutions lie thousands of well-paid executives who would have lost big if the Fed didn’t come to their rescue. Even though they had more information and experience at risk-taking than the suckers who borrowed their money, and even though executives at the top of these institutions typically earn more in a day than the borrowers do in a year, moral hazard somehow doesn’t apply to them.

When it comes to risky behavior in the market, America has a double standard. We’re told that economic risk-taking as the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it’s amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. Some are well known, such as the Chrylser bailout of 1979, the savings and loan bailout of 1989, and the airline bailout of 2001. Most occur in the relative dark, such as the 1998 bailout of giant hedge fund Long-Term Capital Management (courtesy of former Fed chair Alan Greenspan), the not infrequent bailouts of under-funded corporate pension plans by the government’s Pension Benefit Guarantee Corporation, price supports for big agribusinesses facing market downturns, or the current bailout of Wall Street being engineered by Ben Bernanke’s Fed. Behind every one of these bailouts are CEOs or financial executives who were rescued from their bad bets.

CEOs get away with stupid mistakes all the time. Some, like Robert Nardelli, the former CEO of Home Depot, drive their company’s stock low that their boards eventually oust them. But they leave with eye-popping going-away presents nonetheless. (Nardelli got several hundred million dollars on his departure.) If you’re an average American who gets canned from his job, even through no fault of your own, you probably won’t even get unemployment insurance (only 40 percent of job-losers qualify these days). Conservatives tell us that unemployment insurance reduces their incentive to find a new job quickly. In other words, moral hazard.

Some CEOs use bankruptcy as a means of getting out from under pesky labor contracts they might have “known they could not afford” when they agreed to them (Northwest Airlines most recently, for example). Others use it as a cushion against bad bets. Donald (“you’re fired!”) Trump’s casino empire has gone into bankruptcy twice — most recently, last November, when it listed $1.3 billion of liabilities and $1.5 million of assets — with no apparent diminution of the Donald’s passion for risky, if not foolish, endeavor. After all, his personal fortune is protected behind a wall of limited liability, and he collects a nice salary from his casinos regardless. But if you’re an ordinary person who has fallen on hard times, just try declaring bankruptcy to wipe the slate clean. A new law governing personal bankruptcy makes that route harder than ever. Its sponsors argued — you guessed it — moral hazard.

Bush’s “ownership society” has proven a cruel farce for poor people who tried to become home owners, and his minuscule response to their plight just another example of how conservatives use moral hazard to push their social-Darwinist morality. The little guys get tough love. The big guys get forgiveness.

You can argue with some of Reich’s examples, but the general picture isn’t wide of the mark.

I’ve come to wonder whether one of the defects of capitalism American style is our notion that corporations (when managed correctly) are inviolate entities. If the company goes down in flames, unless there was fraud, the managers and directors can dust themselves off and move on to the next situation.

Commonwealth countries set a much tougher standard. If a company is found to have been “trading insolvent,” meaning it is continuing to operate even though it is technically bankrupt, the directors are personally liable:

Under UK law, if a company is trading insolvent, a director may be liable for wrongful trading. If the director knew or should have known that the company could not avoid becoming insolvent but still continues to trade then he or she must cease to trade immediately and take steps to liquidate the company.

The director of a company which is facing financial difficulty should ensure that there is a reasonable prospect that the company will avoid insolvent liquidation before being party to any decision to trade on…..

Directors may escape liability for wrongful trading if they can prove adequate steps were taken to minimise the loss to creditors after it became apparent that the company was insolvent.

Now I am sure there will be howls from the audience. Our corporate bankruptcy system allows businesses to reorder their affairs and survive. Forcing them to fold at the first sign of trouble is inefficient. And the prospect of personal liability would discourage new business formation and keep good people from serving on boards.

Let me deal with the arguments in reverse order. There are plenty of people who would like a corporate directorship, and UK and Australian companies don’t seem to be wanting in capable directors. In fact, a tougher regime might weed out people who are more interested in the prestige and networking opportunities and less keen about rolling up their sleeves.

As for deterring new business formation, many (most?) new businesses are sole proprietorships or otherwise unincorporated. Moreover, credit cards (along with personal savings, friends and family) are a major source of funding for small businesses. Read the fine print of that corporate credit card agreement. The card issuer can go after the business owner in the event of default. So many small business owners have put their personal assets at risk.

As for the virtues of our bankruptcy system, that’s been debated in the academic literature and the jury is still out. While there is a belief that Chapter 11 encourages risk-taking, it may instead be that the causality runs the other way: our society is more tolerant of risk taking, hence of washouts, and that’s why we have the bankruptcy laws we have. In other words, even if the UK and Europe adopted US style bankruptcy laws, the stigma they attach to failure might mean the legal change would not lead to much difference in behavior.

If you look at Reich’s examples of welfare for the rich, quite a few would have been forestalled if the US shared the UK’s attitude of not letting the equity holders take too many liberties with their creditors. And who know if a more tough minded attitude towards making good on one’s commitments might have a broader impact on the business culture.

Whether Bernanke cuts interest rates this month will say a great deal, not just about him, but about the society in which we live.

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  1. Anonymous

    I am a fervent proponent of decoupling Wall Street from all forms of preferential treatment by the Fed. I also realise, it can’t be done with the existing system of patronisation.
    It leads to a need for “Mao’s” revolution to clean out the corruption of Wall Street. Who’s to do it – a new breed of bankers – the Joes and Sallies of Main Street economy.
    How ? Stop paying your credit card debts, monthly mortgage repayment, your taxes to the government – en bloc. Can Americans rise up to this ? Well, not so long ago, a South American country did !

  2. James

    Totally agree that the next meeting is key. If mainstreet America begins to think the whole system is rigged to bailout insiders then there are going to be major longterm consequences for the whole country. A weaker dollar, higher gas and commodity prices are likely and that could be the trigger for some very bad social unrest. Very touchy situation.

  3. Anonymous

    Mix big business, special interest groups and big government together and the socialist crony capitalism that results destroys all in its path.

    Go Ron Paul!!!!

  4. Martin

    “I’ve come to wonder whether one of the defects of capitalism American style is our notion that corporations are inviolate entities.” Bingo.

    Nothing against the capitalist financial system – it’s great. But the Supreme Court ruling (not even an actual ruling I believe) that corporations have the same Constitutional rights as natural persons is a travesty. Corporations are not “natural persons” by any stretch of the imagination and are not treated as such by any other country in the developed world.

    These Constitutional rights unnaturally extended to corporate entities have caused unintended distortions in the capital, legal and most noticeably political structures in the US.

  5. a

    “Translated, this means that lenders, credit-rating agencies, financial intermediaries, and hedge funds will be bailed out, one way or another, because they’re simply too big to fail. Note that behind every one of these institutions lie thousands of well-paid executives who would have lost big if the Fed didn’t come to their rescue.”

    This doesn’t seem to me a great translation. At the moment there are several hedge funds on the brink, a lot which have lost or haven’t made much money, IB banks whose splendid first half results have been or are being pissed away, and bank stocks well down (those executives received a fair amount of compensation in stocks and stock options). And, if the money-market problems continue, expect at least one IB to go under. So at the moment there is a fair amount of sanctioning going on.

    Unfortunately, we don’t allow past bonuses to be taken back, and the U.S.A. has an income tax rather than a wealth tax.

  6. Anonymous

    Well said “a..”

    You know how those fat cats at Wall Street “cook the books” to recognised all sorts of income in one Financial year and in the next, they say “oops, we made a mistake, we need to reverse those income for the last 5 years”. Good, but how about reversing the giant performance bonus payouts ? Anyone has the legal REDRESS for that ?Yes, they lose their jobs with $ millions in “walk-out” compensation, for blowing a hole in the company and putting 1000’s of Joes and Sallies out on the street without their health insurance. All these while the Unions are sleeping – negotiating a $2.00 per hour rate increase and a few minutes off from work hours. Get real, UNIONS!
    Shareholders ? Compensation committees ? Really, which of these are not so copulated, that they can tear each other apart – they sit on each other Boards like the game of musical chair over different time periods – its an institution on its own !

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