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A worker carries a box out of the U.S. investment bank Lehman Brothers offices in the Canary Wharf district of London in this September 15, 2008 file photo.
Reuters/Andrew Winning
Morally hazardous.

The most memorable phrase of the financial crisis taught us the wrong lesson

Nikhil Sonnad
By Nikhil Sonnad


Ten years ago, the 2008 global financial crisis brought on worldwide recessions and fears of total economic collapse. It also introduced the public to a pile of incomprehensible financial terms, from “subprime lending” to “mortgage-backed securities,” “shadow banking,” and “tranches.”

One phrase from the crisis is more iconic than any other, though: “too big to fail.” Unlike the word vomit of “collateralized debt obligation,” this one is fairly easy to parse. It means that some institutions are so large and essential to the functioning of the economy that they cannot be allowed to collapse, no matter the cost to the taxpayer. This was the logic behind the $182 billion bailout the US government provided to AIG, for example, along with the relief funds directed to titans like JPMorgan Chase, Citigroup, and the Big Three automotive companies.

The already-memorable phrase was further ingrained into public consciousness thanks not only to news coverage at the time, but to a best-selling book by Andrew Ross Sorkin and subsequent movie. It eventually found its way to the highest level of American idiom: crappy T-shirt slogan. “Too big to fail” taught Americans something about finance and big business. Today, it is a lens through which we look at the world. It allows us to think about questions like, “Is Facebook too big to fail?” It helps us consider the roles that massive companies and institutions play in our society.

But if “too big to fail” is the main lesson we take away from the crisis, we’re hardly better off than we were before. There is another phrase that offers a more important historical message. That phrase is “moral hazard.” It is the better half of “too big to fail”: the Batman to its Robin, the Simon to its Garfunkel.

Moral hazard refers to an observation about human nature: When people are protected from the downsides of risk, they tend to take on more of it. Or as a 1996 op-ed (paywall) in the St. Louis Dispatch put it, “if you cushion the consequences of bad behavior, then you encourage that bad behavior.” The term is thought to have been coined (pdf) by fire insurers in the 19th century, who distinguished between unpredictable, natural disasters and the preventable ones caused by human behavior. The second category were called “moral” hazards. In the context of finance, if the leaders of major banks feel confident that they are too big to fail—that is, that the government will bail them out if they get into trouble—they will make more and more daring bets, assured that taxpayers will come to the rescue even if all of those bets turn out to be crap.

The idea of “too big to fail” (hereafter TBTF) helps us think about how to deal with an existing crisis. But it is “moral hazard” that gives us insight into why crises happen in the first place, and how to prevent them.

How was it, for example, that financial institutions felt comfortable taking on risks so great that they became ever-more large and shaky—that is to say, very big and inclined to fail? Answer: moral hazard. Investing is a probabilities game, and the feeling that there is a chance the government will come to the rescue changes the calculus on borrowing vast sums of money and using it to make long-shot bets.

Moral hazard also offers us insight into the ever-so-cozy relationship between politics and finance. During the crisis, when then-Treasury secretary Hank Paulson wanted advice on how to handle things, he asked—guess who?—the leaders of the “too big” banks, including his former colleagues at Goldman Sachs. Now these banks have only gotten bigger. Moral hazard asserts that ties between bankers and politicians create dangerous incentives for both parties: a point on which the Wall Street Journal op-ed section agrees with (paywall) an ostensible political rival, Elizabeth Warren, who denounces (paywall) the “regulatory capture” of the government by banks in her latest book.

But moral hazard can help us in areas beyond finance. My colleague Jenny Anderson, for example, employed the idea to get her kids to pack their own school bags in the mornings. She realized that by packing their bags herself, she had been insuring her children against the risk of forgetting their homework or lunch. When it comes to Facebook, the term can help us understand why the social-media giant keeps screwing up: It faces no legal downside if users post racist, hateful, or violent content, so it has little incentive to fix its problems.

That said, “moral hazard” is not a particularly catchy phrase. The history of fire insurers aside, it is now a technical term used primarily by economists, the same people who invented the impenetrable term “quantitative easing.” On the spectrum of clarity, it is closer to “collateralized debt obligation” than the intuitive “too big to fail.”

It might be best, then, to recast the concept as something less economist-y. Perhaps we could start referring to the need for people to have “skin in the game,” the titular phrase of former trader and financial philosopher Nassim Taleb’s new book.

That’s the kind of idea that really deserves to be emblazoned on T-shirts. Just think: How would Facebook, banks, or seven-year-olds behave if they truly understood that they would be held personally responsible for their actions?

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