Personal responsibility hailed as best way to avoid ‘moral hazard’

HPU professor Ken Schoolland says harm to society can be minimized if individuals are responsible for the own actions

How do well-intentioned government policies create morally hazardous incentives?

That was the driving question of Hawaii Pacific University economics professor Ken Schoolland’s April 24 interview with Joe Kent, executive vice president of the Grassroot Institute of Hawaii.

Schoolland, a Grassroot Scholar and author of “The Adventures of Jonathan Gullible: A Free Market Odyssey,” defined the concept of “moral hazard” as “encouraging reckless behavior by not allowing people to be responsible for their own actions.”

He explained that without government subsidies or mandates to encourage behavior to the contrary, insuring properties in areas prone to natural disasters would be either prohibitively expensive or entirely unavailable, thereby discouraging construction in such locations.

But in Hawaii, legislators mandated insurance companies to offer relatively affordable coverage in high-risk lava zones on the Big Island. Consequently, homes were built in areas vulnerable to volcanic activity, and later, many of them were destroyed during the 2018 eruption of Kilauea.

Schoolland cited banking as another industry fraught with moral hazards, arguing that taxpayer-funded bailouts and assurance programs, while purported to stabilize the financial system, actually encourage riskier behavior.

“It’s the risk of failure that causes sound banking behavior,” he explained. “Banks, if they feel that they’re too big to fail, then take a lot of risks that they wouldn’t otherwise take.”

Schoolland acknowledged the natural inclination to sympathize with those who suffer losses as a consequence of their risk-taking.

However, he argued against government intervention, which uses “the force of law and taxes to compensate people for their erroneous behavior.”

“The way you build good, mature judgment is to allow people to make mistakes on their own,” said Schoolland. “Don’t stand in as big daddy, always willing to prevent them from making a mistake.”

To view the entire interview, click on the image below. A complete transcript follows.

4-23-24 Ken Schoolland discusses “moral hazard” with Joe Kent

Kent: Aloha and welcome to the Grassroot Institute of Hawaii. I’m Joe Kent, executive vice president of the Grassroot Institute and today my guest is Ken Schoolland. He’s an economist and professor at Hawaii Pacific University and author of “The Adventures of Jonathan Gullible, A Free Market Odyssey.” So welcome to you.

Schoolland: Thank you very much, Joe. It’s great to be here.

Kent: Today we’re talking about moral hazard, which is a very wonky term. People recoil at it just because it’s confusing to think about, but what is it? How would you even describe moral hazard?

Schoolland: Well, it’s encouraging reckless behavior by not allowing people to be responsible for their own actions.

Kent: The way that I can understand it is, it’s like when you have — it warps your view of risk, basically. So if you’re careful about something, but then you realize that actually someone else is gonna bear the risk instead of you, then you’re not gonna be so careful about it. And then it changes your behavior.

It’s weird that it’s called “moral” hazard, by the way, though. It makes it sound like it’s sinful or something like that. But really, it’s talking about incentives.

Schoolland: Well, it identifies a responsibility, and that’s why it’s a moral action to — are you morally responsible for your own actions, or can you shift that responsibility for your actions to other people?

Kent: And shifting happens often when the government gets involved in trying to shift the risk from person A onto person B in order to help person A. And there’s nothing wrong with that picture, right? [laughter]

Schoolland: Yeah, it’s a sympathy that people might feel, but the problem is with the government, they use the force of law and taxes to compensate people for their erroneous behavior. I think you could think of some examples here in Hawaii. Over on the Big Island, there are a lot of volcanoes. Everybody knows about that.

You can see the maps where it shows that there are risky zones, and you wouldn’t want to build a house there. Well, you might want to build a house there because the view is spectacular over the ocean and the volcanoes and all that, but no bank is going to finance it if you can’t get insurance and no insurance company is going to take the full responsibility for that sort of thing.

Kent: Hey, can I build under an active volcano? No? Why not? You know, like that, right?

Schoolland: Right. I mean, for one thing, they won’t even insure you, but if they thought that there was some reasonable expectation that you could cover those, the price for that insurance would be through the roof. It would be very, very expensive.

Therefore, the insurance company is evaluating the risk and charging you a premium for that.

But then in the state of Hawaii, of course, the state Legislature got involved and said, “Well, no, insurance companies have to insure people all across the state, if they want to practice insurance here in the state.”

And so, a lot of people had their houses on the Big Island in dangerous zones insured, and therefore banks financed them. And then the volcano erupted and destroyed thousands of homes. 

So that was the kind of behavior that people would not have done if they had to carry those risks themselves or if insurance companies had to carry those risks themselves.

Kent: But what about the fact that if people can’t build homes, though, then we have a housing shortage and you know the Legislature needs to step in and make sure that we guarantee some kind of insurance for people where it’s difficult to get insurance.

Schoolland: The shortage of homes in Hawaii isn’t because we’re not allowed to build on active volcanoes. It’s because we’re not allowed to build in safe areas.

The vast areas of Oahu, Maui, and Kauai that are very, very safe for building, they’re not zoned for housing, and so people can’t build houses there. 

But instead, if they’re insured that they can build on the coasts of the Big Island, well, then people will choose to build in places that are going to cost them. And if the part of the cost is your risk, you’ll choose to build in a safer place.

Kent: It would almost be similar to trying to get insurance for a house that was already on fire. You know, you can’t get insurance for a house that’s already burning down. In the same way, you can’t get insurance for a house that’s highly likely to burn down. Is that right?

Schoolland: That’s right. And the same thing goes for federal flood insurance. You’ll notice that the government has offered very, very low rates — or mandated low rates — for building at the coastline or along the riverfront where there’s going to be flooding or where there’s going to be storms or hurricanes.

Well, people normally wouldn’t build in those places because it’s too risky. You know, lots of storms wash away the shoreline to tear down the house and all that.

And so, insurance companies aren’t going to finance them, and therefore aren’t going to insure them, and then banks won’t finance them and so they don’t get built. People build in safer places further up the hillside and away from these danger zones.

But since the federal government started federal flood insurance, offering very low taxpayer-subsidized rates, a tremendous amount of population growth has occurred, especially in 20 counties that have gotten the bulk of this kind of insurance, where that’s by far the greatest danger. But they’re attractive to wealthy builders. They want to build where the view is nice.

In one case, I think one guy lost his house 18 times to storms and damage, and yet the government rebuilt it for him each time. And the insurance was very, very cheap for him. So it was no problem for him.

The cost was borne by the taxpayers and all those other people who don’t take that kind of risk for their own lives.

Kent: So how does that work though? If the insurance companies are forced to insure people whom they would not otherwise insure, then how is the taxpayer involved though?

Schoolland: Well, in federal flood insurance, it’s the government itself that’s the insuring agency, and then the taxpayers pay any losses. I think it cost them some $50 billion in losses, largely encouraged by encouraging people to build in very, very reckless places.

Kent: So we’re talking about a warped market and warped incentives, and it warps what you do, though. 

It seems, though, a lot of this warping happens in disaster situations though. Why is that? You know, we’re talking about floods and earthquakes and hurricanes and so on.

Schoolland: Well, life is filled with various risks. And so in every aspect of life, you’re making judgments for yourself on where is a wise course of action or a reckless course of action.

You might say that people take more risks hiking up in the mountains if they feel that the government will come and rescue them.

I think if you actually had to buy insurance for that sort of thing, the insurance company would evaluate what kind of a hiker you are and where you’re going and then charge you a rate based on what your risk is.

Kent: And they actually do have, you know, the government does come out and rescue hikers all the time in the mountains. You see emergency helicopters from the state or county rescuing people. That’s a good thing though, right? I mean, we wanna save those people.

Schoolland: Of course, but if they feel there’s no risk, they’re more inclined to be going into risky areas.

Kent: Oh, I see. If they don’t have to pay for the helicopter.

Schoolland: So if they had to pay for an insurance fare that would cover their risks of going into a dangerous zone, they might say, “Ah, well, we’ll do a different kind of hike this day.”

Kent: I see. OK, so we’ve got floods, we’ve got lava, we’ve got hiking, but going away from the insurance market though, what about banking? Is there moral hazard there?

Schoolland: Oh, absolutely. And this comes in the form of the Federal Deposit Insurance Corp., the Federal Reserve System, numerous government agencies — numerous government agencies. I think there are some 24 government agencies that were involved with evaluating and providing various kinds of bailout and risk assurance in the last great recession that we had.

By providing these assurances, in a sense, it creates a moral hazard in the banking world as well.

Banks, if they feel that they’re too big to fail, then take a lot of risks that they wouldn’t otherwise take. Why? Because the stockholders and CEOs aren’t really fully carrying the responsibility of their actions, and depositors don’t really look around to see what’s a safe bank and not a safe bank. They just figure, well, which one’s most convenient? Which one has the nicest building?

Kent: And “too big to fail,” by the way, is a term we heard a lot during the 2008, you know, banking crisis era and everything. But we haven’t heard that too much recently though.

It basically speaks to the idea that so much of society uses the banking system and especially certain banks, and if those banks fail, well that’s a huge sector, that’s a huge chunk of our society that now may not have access to their funds, right? 

So I mean, isn’t there something to the idea of “too big to fail” if we’re all using the same bank that fails?

Schoolland: That encourages them to get very big and very risky. In other words, how are you gonna get — you wanna be — take on as many loans as possible to get a big return?

Well, how do you get a big return? By taking greater and greater risks to where you invest your money. 

And if you don’t have to worry about the downside that you’re going to lose your money and you’re going to — all of your stocks are going to be worthless or your CEOs are going to lose their jobs and get penalized and all — then why not take the greatest risks of all. And that’s what they did in 2007, 2008.

And the Federal Reserve Board fueled this by enormous expansions of credit, very, very low interest rates.

And then, of course, this encouraged this massive lending. And a lot of lenders were encouraged to go ahead and accept these risks because they assumed, well, it’s such a big bank, the federal government isn’t gonna let it fail. So they get bigger and bigger. So you encourage these bubbles. 

Kent: I see, so by shifting or, quote-unquote, reducing the risk somehow, taking the risk out of the equation, it actually incurs more risk, right? Now we get bigger banks that are even too much bigger to fail, if that’s even a phrase.

And actually, there’s no guarantee that they won’t fail either, right? 

We’ve seen bank failures of recent years. Just last year we had the Silicon Valley Bank and a few other banks that went under.

But what about the future? I mean, do you think that if bank failures appear in the future that we’re going to let them fail or is the government gonna step in?

Schoolland: Oh, it’s inevitable that they will fail because this is the constant pattern of the boom and bust cycle. All the time the government is getting — and the Federal Reserve Board is getting credit for the boom — “Ah, we have booming times. Everybody’s prospering, and the economy’s doing well” — but this is a bubble that pops because it’s of redirected investment towards risky and mal-investment — bad investment. 

So when it pops, then other things in the market are things that take the blame for that when in fact it was the Federal Reserve Board that created this bubble in the first place.

Kent: Let’s talk about the pain though. I mean the flip side of moral hazard is pain. If we don’t step in to help then there’s going to be enormous pain somewhere in the economy. And what about that? 

If a bank fails, think of all the people that would be hurt by that. Same thing with all the other situations involving moral hazard. What about businesses that experience all this pain because of it?

Schoolland: Well, it’s the risk of failure that causes sound banking behavior. In other words, the fact that they could get into too much risk and fail causes them to be careful and cautious.

So you’re more likely to have this boom of reckless behavior and reckless spending because you’ve taken away the risk. And so then you’re more likely to have the heartache and the pain.

Now, let me say that with the government’s interactions, what they do is they intervene with massive increases in the money supply — “quantitative easing” they call it — by the trillions of dollars, tremendously increase the quantity of money to buy up these failed assets — mortgages and corporate bonds that have been failing.

OK, who bears the cost of that? I would say that inflation — it generates inflation — the more money they create, reduces the value of it. That’s why you put counterfeiters in jail because counterfeiters print money, take products away from people, diminish the value of other people’s money — they put them in jail. But when the government does it, it’s called monetary policy.

Kent: So there’s no way to get rid of risk altogether. All you’re doing is pushing it out and you’re spreading it out somewhere, you’re sweeping it under the rug, you’re manifesting it into inflation, which we’re seeing right now, which inflation is really harmful too, by the way.

Schoolland: Not just “too.” It’s the main form of redistribution of wealth from the poor to people who are well entrenched with properties and gold and stocks and other things that go up in value in times of inflation. 

But those who are paying for it are all those people on fixed incomes with savings and pensions and stuff that lose purchasing power.

It’s a tremendous transfer of wealth, a redistribution of wealth from low-income people to well-entrenched higher-income people. 

Inflation is, I consider, a kind of theft, secretly and unobserved, that confiscates a vast amount of wealth from people and puts it into the hands of others.

And that’s why I consider this a form of moral hazard because the politicians that play the game of bailouts and rescues of people getting in, of big banks and big corporations that get into trouble, they’re on the receiving end of massive campaign contributions, what I call the iron triangle.

Special interest groups give campaign contributions or other kinds of favors, speaking fees by the millions of dollars and so on to politicians in power. They establish law, which establishes government agencies that provide enormous subsidies.

And for one dollar of campaign contributions, you can get thousands of dollars of subsidies and benefits. There’s no better investment in the world than the well-placed politician.

And the politicians that don’t play this game, they can’t really compete in the election cycle. They are less likely to have the campaign contributions and publicity and acknowledgement, whereas those that play the game are more likely to be seen and rewarded and popular in the political arena because they’re doing “action,” right?

Kent: Right, right, I see. Yeah, there was just a big expose about that in Hawaii where they showed that hundreds of thousands of dollars were going to politicians who were then rewarding the business owners with huge government contracts, and round and round she goes.

And so that’s part of this whole moral hazard thing too. Now the money system and the political system is warping even politicians’ morality, is what you’re saying. An honest politician is less likely to do that, and they won’t get their reward either.

Schoolland: And there’s a way to recognize that the government is the biggest beneficiary from inflation. Look who gains the most from inflation. It’s the one who is in debt gets to pay back in cheaper money. The one who owns land and real estate, the one who owns gold, collectibles. 

Well, no entity in society has more debt than government, more land than government, more gold than government, more collectibles such as the museum pieces all around and government museums.

Kent: That’s right, they have all the art too it seems like.

Schoolland: That’s right and they get to print the money and spend it first before the prices go up. So it’s throughout history — even from the ancient times when Caesar was printing, you know, reducing the quantity of silver in the coin in order to create more coins — it was a transfer of wealth to the creator of the coin.

And in this case, it’s the Federal Reserve Board creating money on behalf of the government.

Kent: OK, but now I buy what you’re saying here, which is that this whole moral hazard can lead to all kinds of problems, so let’s not even go down that road to begin with, and let’s live with the problems and downside and pain that’s more natural and that the free market sort of naturally imposes and so on.

OK, but we’re already down that road. We’re down the road of moral hazard very far. And so if we try to unwind it, that will cause pain.

So let’s go back to a local example. We’ve got the Honolulu condos, right? Condominiums in Oahu and across the state are old, they’re decrepit, you’ve got broken pipes and rusted elevators and railing and cracks.

And so these condos are so old, they haven’t been maintained — well, some of them — haven’t been maintained well enough such that the insurance industry is saying that there are several buildings that are uninsurable. 

No insurance company will insure these buildings and so they have to go on the secondary market where insurance rates kick up 1,000%.

And so the government now has a bill at the state Legislature. “We’re gonna solve this problem through taxation,” right? “Let’s tax not you or me but tax that fellow behind the tree and he’s gonna pay for these — for the insurance so that these buildings can get their act together.”

So what’s wrong with that?

Schoolland: Well, I think that the real reason that the shortage of housing in Hawaii isn’t that we can’t quite remodel this particular condo, it’s the fact that so little housing is available as the alternative. I would say that people would long ago have built other kinds of housing if there weren’t so many barriers in terms of regulatory control, zoning, and taxation, and all the restraints on the building of housing in the islands here.

If there were a lot of other housing available, they might have just torn that condo down and built up something new. But who could wait for the regulatory delay and the cost of all that, you know, to tear down the old building and build up a new one?

Kent: I see. Upgrading buildings, regulation even hinders the upgrading of buildings, you’re saying.

Schoolland: Yeah, yeah, yeah, yeah, right.

Kent: Well, now that we are illuminated, now that we are enlightened about moral hazard, what is your sort of philosophical lesson, if there is any, about the lessons of moral hazard?

Schoolland: Well, I think it’s personal responsibility, and if you do so then you are more likely to make good judgments about how you’re going to live your life. 

I mean I don’t tell my daughter that when you’re growing up every accident that you’re going to make, every mistake you’re going to make, I’m going to rescue you, I’m going to bail you out.

I would encourage her to grow up as an irresponsible person who couldn’t take care of her own thinking about her own life. Then I’d be forever her guardian. I wouldn’t ever be able to let her out of the house because I wouldn’t trust her on her own.

So the way you build good, mature judgment is to allow people to make mistakes on their own, but don’t stand in as big daddy, always willing to prevent them from making a mistake.

Kent: So we shouldn’t nanny our kids too much and the government shouldn’t nanny us too much, right? The nanny state, right?

So it’s just been so awesome talking with you about this today. And we’re going to talk more and more about all kinds of different economic concepts with economist Ken Schoolland. 

And thank you so much for joining us. Aloha.

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