Cecchetti & Schoenholtz — Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

Money and Banking

Moral Hazard: A Primer
Stephen G. Cecchetti, Professor of International Economics at the Brandeis International Business School, and Kermit L. Schoenholtz, Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business

Cecchetti & Schoenholtz are the authors of Money, Banking and Financial Markets.

Noah Smith — The Dirty Little Secret of Finance: Asymmetric Information

Noah gets one right.

There’s a very deep, important concept in economics that gets way too little attention from the public (and possibly from economists themselves). This is the idea of asymmetric information. The concept has been around for decades, and research about it has won Nobel prizes, but neither the profession nor the public has ever put it at the center of our understanding of markets. That should change.

A bigger issue than asymmetric knowledge is asymmetric power. That is not to be mentioned in either finance or economics. These are two of the chief tools involved in rent extraction and they are generally disregarded in neoclassical economics.

Bloomberg View
The Dirty Little Secret of Finance: Asymmetric Information
Noah Smith