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Coming to Grips with Moral Hazard

Global Economic Forum
The latest views of Morgan Stanley Dean Witter Economists
Stephen Roach
July 24, 2000
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The New Global Economy is more dependent than ever on financial markets. That's partly a by-product of globalization and the associated cross-border spillovers between markets and economies. But it's also a function of the enhanced role of wealth creation in a low inflation climate. As financial markets become more and more vital to real economic activity, greater burden falls on the authorities to protect this new engine of prosperity. This is a delicate and critical task. It points up the increasingly important moral hazard dilemma facing policy makers: How far should they go in nurturing the financial market support to the global economy?

The crisis-prone 1990s brought this issue to a head. Each of the three major crises of the decade -- the ERM crisis, the peso crisis, and the global currency crisis -- forced policy makers to step up and stabilize distressed markets. Speculators and other investors were quick to catch on. They began to trust in the ever-present bailout. Financial markets, themselves, had effectively become too big to fail. Risk premiums shrank and yield-hungry investors showed little fear. The repercussions of the Russian debt default -- especially the near failure of Long Term Capital Management -- demonstrate with painful clarity how serious the moral hazard dilemma had become. The seizing up of global capital markets in late 1998 was a warning shot that hadn't been heard in 65 years. The world had truly been taken to the brink. It was imperative that the authorities come to grips with moral hazard considerations before the proverbial next crisis pushed the global economy over that brink.

The good news is that important progress is now being made on this front. First and foremost are efforts at reforming the international financial architecture. The 8 July proposal of G-7 finance ministers was aimed squarely at the moral hazard dilemma. By raising the interest charges on normal IMF-ending lines, the mix of development finance should shift away from official IMF-sponsored credit lines and toward private sector arrangements. In the event of loan repayment difficulties -- quite frequently the spark for a currency crisis -- private sector creditors would then be on the front line of facing exposure to market risk and in leading subsequent loan work-outs. Such burden sharing is the only effective counter to moral hazard imperatives in times of international crisis, in my view. Only then could bailouts -- the all too familiar public sector responses to crises of the 1990s -- be replaced by "bail-ins" involving the private sector.

Secondly, there are signs that the Japanese authorities are starting to face up to their own moral hazard dilemma. Bank of Japan Governor Hayami seems quite intent on bringing ZIRP (zero-interest-rate policy) to an end; in our view, it is now a question of when, not if. Moreover, the LDP leadership seems to be changing its posture with respect to corporate bailouts. The recent willingness to permit bankruptcies of Shogo and Seiyo suggests that the so-called Japanese convoy system is now being drawn into serious question. Finally, there is clear consensus amongst Japanese policy makers that fiscal stimulus has gone much too far. All in all, it appears that the Japanese authorities have made a conscious decision to wean the nation from undo reliance on policy stimulus and financial market support. It remains to be seen if the economy is strong enough to allow this strategy to be implemented in the second half of 2000.

Thirdly, Alan Greenspan appears to have a stealth moral hazard campaign of his own under way. The issue in this instance is the US stock market -- and the Fed's recognition of the crucial role being played by the so-called wealth effect in generating excessive growth in aggregate demand. To the extent that US monetary authorities foster policies that provide open-ended support to the stock market, speculators and other investors will attach a lower risk premium to equities as an asset class. Against that backdrop, the stock market will continue to draw its sustenance from a deeply entrenched dip-buying strategy. But Fed efforts to slow the economy down should have adverse implications both for interest rates and corporate earnings -- thereby tempering the excesses of the stock market. Moral hazard concerns raise the question as to whether the Fed has the courage to stay this course.

The tightening campaign of the past year reveals a Federal Reserve that is attempting to stress-test the vulnerabilities of a wealth-dependent US economy. The main risk, of course, is that the market corrects too sharply. That could trigger a powerful asymmetrical wealth effect that might wreak havoc on the real economy -- and spark a Fed easing. Expectations of such an endgame fuels perceptions of a US stock market has become too big too fail. In that regard, I must confess to having been slightly disappointed at the tone of Greenspan's 20 July congressional appearance. By tempering the hawkishness of his prior testimony given in February, the Fed Chairman sent a message that could hearten equity investors -- very much at odds with his earlier concerns of the wealth-driven excesses of aggregate demand. If the equity market surges in response to a perceived "all clear" signal, the moral hazard concerns of equity targeting would once again be center stage in the US.

The moral hazard dilemma tugs at the fabric of the New Global Economy. As financial markets have taken on greater importance in shaping real economies around the world, investors essentially have come to the conclusion that the authorities will always provide the ultimate backstop. This has distorted risk premia and led to a recurrence of crises. A lot has been written of the virtuous circle that underpins world financial markets. Moral hazard concerns shape the vicious side of this same circle. Slowly but surely, the authorities now seem to be coming to grips with this critique.

Copyright 1999, 2000 Morgan Stanley Dean Witter & Co.