Latticework of Mental Models: Moral Hazard

Millions of years ago, before the agriculture revolution, when homo sapiens was still living life as a hunter-gatherer, there was this one naturally occurring phenomenon which aroused a sense of wonder, fear and longing at the same time in his mind. The phenomenon occurred on its own in nature and humans found it very useful but it espoused extreme dread too because of its destructive capabilities.

I think you can guess what I am talking about. That natural phenomenon was fire!

About 100,000 years ago, humans finally learned how to create fire and it accelerated the development of human race. Fast forward to this day. Even after having developed technologies to create, douse and control all sorts of fires, wildfire is one thing where humans have found themselves helpless in front of mother nature.

Wildfire kills 339,000 people every year[1], even today! So why we haven’t been able to do much about wildfire carnages? Agreed, we can’t prevent a tsunami or an earthquake but we can surely prevent and contain a fire. Right?

The surprising truth is that with the help of modern technology the number of wildfires have come down drastically over the last hundred years but the total destruction caused by these fires hasn’t gone down proportionately. It even seems to have increased.

That’s perplexing, isn’t it? Is there something wrong with these wildfire prevention efforts? Of course we aren’t doubting the intentions of these fire prevention squads. Here is a hint from famous philosopher Karl Marx who said –

The road to hell is paved with good intentions.

This takes me back to the year 1991. “Why can’t government print lots of money and distribute it to the poor?”, as a 10 year old I remember asking this from my social science teacher. It was puzzling to me that why wasn’t the solution obvious to government.

“Printing money is a bad idea because it will solve the problem in short term but it will increase the inflation.” My teacher explained to me.

Of course I had no clue what inflation meant and I wasn’t the curious type so I left it at that. It took me another decade and a half to finally understand the relationship between inflation and currency supply.

I know I haven’t uttered a single word about our mental model for today, but please bear with me. You patience will be rewarded well.

Let’s return to our wildfire conundrum. Frequent wildfires are mother nature’s mechanism to get rid of the inflammable biomass that accumulates in forests. Every time someone intervenes, with all good intentions, to suppress these relatively smaller wildfires, it sets the stage for bigger, meaner and deadlier conflagration.

Because of artificial suppression of the smaller fires, people living in those areas assume that the risk has gone away. This may attract more people to inhabit those areas and eventually when the bigger fire erupts (with more than enough fuel in form of unused biomass), not only its size and intensity is much higher but it engulfs a much larger area. The effect is non-linearly amplified. Suppressing five small fires doesn’t result in a five times bigger fire, it could mean a 10 times bigger fire.

Howard Marks, author of The Most Important Thing[2], writes –

The government’s long campaign to tame wildfires has, perversely, made the problem worse. . . . By stamping out most wildland blazes as quickly as possible, the Forest Service has stymied nature’s housekeeping – the frequent, well-behaved fires that once cleaned up the pine forests of the Sierra Nevada and the Southwest. Now, woodlands are tangled with thick growth and dead branches. When fires break out, they often explode…. the policy of fighting fires early also created moral hazard by encouraging people to build homes further into the forest.

Please note the word ‘Moral Hazard’, because that’s our mental model for today.

Moral hazard describes a situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. As a result, a party, which does not bear the true costs associated with its action, is likely to behave in a reckless fashion.

A simplest example would be the business of insurance. Someone who has a fire insurance for his house is going to be less vigilant about fire hazards like not installing the fire alarms. This creates a moral hazard for the insurance companies. Essentially the risk is not just transferred to the other party but it may even increase.

A similar case with medical insurance too. Medical professionals tend to prescribe more expensive treatment (even if it’s not required) for patients covered under medical insurance.

I hope you remember our discussion on Complex Adaptive Systems[3]. Recall the story of cobra snakes and how government’s policy, incentivising the snake-killing, backfired. It was an apt example of law of unintended consequences, which states that good intentions don’t always result in good outcomes especially when you’re dealing with complex adaptive systems. So it’s not uncommon when the cure turns out to be worse than the disease.

Economy or for that matter stock market is a complex adaptive system, very much prone to the law of unintended consequences. Because of that Moral Hazard is something which needs to be thought about before making any decision.

Every time government prints more money for bailing out a failing bank or a troubled PSU, they are sending a wrong signal which says – it’s okay to take absurd risks because we will protect you. And that sets the stage for an eventual meltdown.

There is a clear analogy between financial crises and forest wild fires. Politicians and economists have a tendency to quickly douse any and every small fire (a bank or institution facing crunch) which leads people to take foolish risks. Just like forest services felt a need to keep those unwisely built forest houses safe, government feels it has to rescue the imprudent borrowers and financial institutions.

Robert Rubin, former secretary of US treasury, in his book, In An Uncertain World[4], describes moral hazards problems at the macroeconomic level –

…insulation from loss can sow the seeds of future crises. Part of the issue in Thailand had clearly been excessive and undisciplined investment from the developed world. ‘Rescuing’ these investors, especially in a relatively small economy like Thailand’s, could encourage lenders and investors to give insufficient weight to risk in pursuit of higher yield in other developing countries and undermine the discipline of the market-based system. In supporting an IMF rescue program, we would be interfering with the free play of market forces. As a result, investors would escape some of the burden of problems they had helped create.

Ironically, Mr. Rubin earned $120 million from Citibank in bonuses over about a decade. The risks taken by the institution were hidden. Citibank collapsed, but he kept his money while taxpayers had to compensate him retrospectively since the government took over the banks’ losses.[5] In the moral hazard equation, Rubin chose to be on the profitable side.

Howard Marks further says –

How can a free-market economy allocate capital effectively if capital creation is abetted and capital destruction is prevented? The fact is, excesses have to be corrected – painfully – and if they aren’t, they’ll just grow bigger and bigger as the cycles wear on. “Moral hazard” will arise, convincing people that risk takers will always be bailed out, something that’s bound to encourage greater risk taking.

If you give it a thought you would realize that a similar thing is currently happening in Indian tech industry where mindless growth supported by venture capital is creating a moral hazard for investors since many of the tech entrepreneurs, having diluted most of their stake, aren’t exposed to much risk. Most of these reckless founders have already cashed on multimillion dollar pay cheques as CEOs and won’t bear the direct risk if the company goes under.

“The idea is simple,” explains Jeffrey Tucker, in an article published by the Mises Institute in December 1998 [6]

If you are continually willing to protect people from the consequences of their own errors, your benevolence will be factored into the future decisions of the persons rescued. In the long run, they will make even more errors. The principle exists at all levels. The teacher who changes grades when students plead hardship isn’t helping in the long run. The teacher is rewarding and thereby encouraging poor study habits. He is creating moral hazard.

Nassim Taleb, author of Antifragile[7], dubs this as transfer of fragility. He writes  –

The worst problem of modernity lies in the malignant transfer of fragility and antifragility from one party to the other, with one getting the benefits, the other one (unwittingly) getting the harm, with such transfer facilitated by the growing wedge between the ethical and the legal. This state of affairs has existed before, but is acute today – modernity hides it especially well.

When a suit-tie wearing middlemen (investment banker) bundles a bad loan as securities to other investors, he doesn’t worry whether the borrower will repay in five years’ time. He gets paid just for making the deal so all he will care about is more quantity than quality. The 2008 financial crisis was largely a moral hazard created by these kind of credit derivatives.

Consider an example of a CEO who is not the owner of the company and has recently been appointed. His pay depends on company’s performance in subsequent year, which means he has all the reasons to take (risky) decisions which will benefit company in short term including the ones which may be detrimental over long term. The way things unfold after that isn’t that hard to guess.

At the end of the first year he goes home with a fat paycheque and few years down the line when business suffers the long term effects of his decision, he is sacked but not without a healthy severance package. Shareholders become the victims of this moral hazard situation.

Seth Klarman, in his 1998 letter to shareholders, wrote –

Investors are strangely willing to ignore the moral hazard of their own behavior, rewarding managements which successfully manipulate quarterly earnings into a steady and predictable uptrend.

And don’t forget that the sacked CEO, having learned that he doesn’t face the risk, will soon be repeating his tactics at some other company, conveniently spreading the moral hazard.

In designing social policies, there is fine line between discouraging entrepreneurship and making them dependent on a safety net. In the long run bailing out people is less harmful to the system than bailing out firms.

Skin In The Game

The solution of course is that nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed. But how?

Warren Buffett offers a solution[8] –

If I were running things and if a bank had to go to the government for help, the CEO and his wife would forfeit all their net worth. … And that would apply to any CEO that had been there in the previous two years. …I think you have to change the incentives. The incentives a few years ago were try and report higher quarterly earnings. It’s nice to have carrots, but you need sticks.

Moral hazard being a problem caused by human behaviour is obviously not a new one and so the solution also exists in the ancient code of Hammurabi, which was formulated 4000 years ago. It says –

If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death.

Therefore you have to redesign the incentives because at the end of the day it’s nothing but an agency problem (incentive caused bias). We need people to have their skin in the game.

Conclusion

Moral hazard is very tightly coupled to other mental models like complex adaptive systems and incentive caused bias. No wonder it manifests as lollapalooza, a confluence of multiple mental models working in the same direction.

I am sure moral hazard isn’t just limited to wildfires, insurance and financial transactions. You must have seen this at many places. Do share your insights, observations and learnings about this mental model in the comments section.

Take care and keep learning.