Walter Molano | The era of moral hazard

OP-ED CONTRIBUTION: EMERGING MARKET ADVISER

SELF-INTEREST IS a tenet of capitalism.

In 1776, Adam Smith, the father of market-based economics, wrote: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from regard to their own interest. We address ourselves not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.”

This is a lesson that we are painfully relearning, as the gears of our economy are brought to a standstill by the preventions needed to limit the spread of the coronavirus.

The problem is that, in the interim three centuries, society has become more complex. The three economic actors Smith uses to illustrate his example, butcher, brewer and baker, are principals. In other words, they act for themselves. However, as business scales grew, principals began to hire agents who acted on their behalf, and problems began to rise when the principals could no longer monitor their agents. This created opportunities for the agents to act in their own interest, and not in the interest of the principal.

In economics, this situation is known as the principal-agency problem, and the behaviour became known as moral hazard. The latter began to compass other behavioural issues, such as acting in bad faith. Nevertheless, it boiled down to the delicate balance between costs and benefits.

Unfortunately, the systemic economic instability due to the coronavirus pandemic is leading to a breakdown in the balance between costs and benefits, and we are about to face an explosion in moral hazard.

Government assistance programmes are creating perverse incentives that will be difficult to eliminate. For example, under the United States’ CARES package, many people are earning more than they were before the onset of the coronavirus pandemic.

Anti-eviction laws are inducing many renters to stop paying rent, whether they need to or not. Banks are being pressured to waive all forms of fees, from ATM to late charges to even interest on loans. Some groups are putting pressure on legislators to force banks to forgive student loans.

Given that the economic downturn is going to persist for a long period of time, this will produce an inordinate amount of damage. It will also create a set of perverse incentives that will be very difficult to eliminate.

For example, municipalities around the world are forcing empty hotels to open their doors to indigent and homeless people. How will they evict these individuals and throw them back on to the street?

A good example of how long these problems can persist is the rent-control measures that were introduced in New York City after World War II. Rent control, or the freezing of apartment rents, was introduced during World War II. Inflation was on the rise, as the demand for goods and services soared in order to aid the war effort. After the war, the controls were left in place in order to help the soldiers who were returning from overseas.

However, the constant rise in costs, including property taxes, forced owners to reduce maintenance and repairs. Eventually, many landlords abandoned their properties, allowing the poorer parts of the city to collapse.

In 1969, the government began to phase out the rent-control system. Nevertheless, three-quarters of a century later, there are still apartments that remain under rent control, having been passed down generationally. The question is, will many of these programmes that are being introduced today still going to be around in year 2200?

To make things worse, moral hazard is not relegated to the microeconomic front. It will also run rampant at the macro level. Governments will see the coronavirus pandemic to be a unique opportunity to walk away from sovereign obligations.

Front and centre is Argentina. The presidential election of 2019 was a brutal confidence shock for the country, as a national leader with a horrible reputation returned to office. Investors, rightfully, assumed that under the new leadership, the country would lose access to the international capital markets.

Although Argentina did not have a solvency problem, the new government asked for a respite to get its finances in order, thus demonstrating to the international community its ability to manage its economy responsibly.

However, given the outbreak of the pandemic, the new government took the opportunity to reduce its debt as much as possible. It adopted an aggressive, non-conciliatory position with creditors, to abrogate its obligations as much as possible.

Other governments will take the same path. A similar situation occurred in 1982, when Mexico became the first emerging-market country to default on its debt. Venezuela immediately followed suit, even though oil prices were at an equivalent level of US$85 per barrel.

The Venezuelan government reasoned that if Mexico was going to get debt relief, why shouldn’t they. This is the postcard example of moral hazard, and it is the danger we are about to confront.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com