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Fed Treads Moral Hazard

Monday, August 13, 2007 | 07:24 AM

in Credit | Federal Reserve | Markets | Psychology/Sentiment

I am exceedingly late this morn, but I had to direct your attention to the front page article of the Money and Investing section of the WSJ: Fed Treads Moral Hazard:

"Wall Street has a dream: that the Federal Reserve will rescue financial markets with a sharp cut in interest rates.

Behind that dream lurks a problem, something financial people call moral hazard.

Moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected.

These days, investors and economists use the term to refer to the market's longing for Federal Reserve interest-rate cuts. If investors believe the Fed will rescue them from their excesses, people will take greater risks and, ultimately, suffer greater consequences. Some grumble that the Fed created problems this way in 1998, 1999 and 2003.

If the Fed were to cut rates now, it certainly could help with the current market crisis. The cheaper money would reduce pressure on stock and bond markets by making it easier to buy beaten-down stocks, bonds and other securities world-wide. Wall Street is a powerful lobby in Washington, and its bleating for help can be hard to resist for politicians, whose campaigns often depend on financial contributions from Wall Street figures.

But if the Fed were to ride to the rescue, the skeptics worry, it would encourage people to speculate even more, creating an even bigger bubble later.

"You don't want to see the Fed bail out these guys who have made a lot of money. They have made their bed and you want to see them lie in it," says a veteran trader at a New York brokerage house. "Then again, you don't want to see the economy go into recession."

That, in a nutshell, is the choice the Fed's policy makers face today.
(emphasis added)

Its a must read -- and for you non-WSJ-subscribers, its free just for today.

graphic courtesy of WSJ

Source:
Fed Treads Moral Hazard
Step In and Cut Rates Or Stand By and Watch: Whither Helicopter Ben?
E.S. BROWNING
WSJ, August 13, 2007; Page C1
http://online.wsj.com/article/SB118696170827295489.html