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Student debt and moral hazard: To forgive or not to forgive?

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During primary elections in the United States, it’s hardly unusual for those seeking their party’s nomination to make outlandish promises that aren’t likely to be kept. Thus we saw Senator Elizabeth Warren recently outlined her plan to abolish student debt, and pay for it by levying a tax on the super-rich (however that is defined). The cost of all this? Senator Warren says about 1.25 trillion (US). She also wants to make tuition-free at public colleges and universities.

All this comes amidst predictions that as many as half of colleges in America face closure in the next 15 years because of 1) a declining market and 2) the fact that young people – and their parents – are working out that a college education isn’t the payoff that it used to be, either financially or in terms of actually receiving an education as opposed to four years of tedious ideological indoctrination.

Beyond, however, all the specifics of Warren’s proposal, I am more concerned about the message that it sends to Americans about the nature of debt and the promises freely made and the obligations freely assumed whenever anyone takes out a loan, whether for education, starting a business, or buying a house. There is an economic and moral dimension to this, much of which is captured in the idea of moral hazard. I discuss this in my 2016 book, For God and Profit: How Banking and Finance Can Serve the Common Good. Here’s a relevant extract which might be helpful for those looking to understand how the workings of moral hazard should help us think through issues of debt-forgiveness.

The origins of the term “moral hazard” lie in neither economics nor theology. They have been traced back to the seventeenth century and the development of the insurance industry. Today it describes a phenomenon summarized by the economist Paul Krugman as “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost of things go badly.”

When economists use the term, they don’t typically mean immoral or fraudulent behavior. Rather it is about circumstances, policies and institutions that encourage individuals and businesses to take on excessive risk, most notably with assets and capital entrusted to them by others, because they safely assume they will not pick up the bill for any failure. Hence, while profits remain private, losses are socialized. Heads, I win. Tails, taxpayers lose. The higher the extent of the guarantee, the greater is the risk of moral hazard.

A good example of how this occurs through government institutions may be seen in central banks. They assume the role of providing liquidity—either directly and/or through organizing private banks, or open-market operations—when a banking system has apparently run out of liquidity. A defining characteristic of a central bank is that lenders of last resort cannot go bankrupt.

The difficulty is that the very existence of a lender of last resort can encourage private financial actors to imagine that they are “too big to fail.” Indeed, if they possess enough systematic presence in a given financial system, they have reason to assume they will be provided with liquidity by a central bank if a failed endeavor threatens their solvency, no matter how foolish or irresponsible their behavior. As a result, such financial actors will become complacent and take risks which become increasingly irresponsible over time.

Economists and others have long debated the overall significance of moral hazard, the extent to which it is a real problem, and the ways it might be minimized. In a 2007 Financial Times column, for instance, a prominent member of the Clinton and Obama Administrations’ economic teams, Larry Summers, argued that we should beware of what he called “moral hazard fundamentalism.” This was, he said, “as dangerous as moral hazard itself.” By this, Summers meant that ruling out significant government economic intervention on the grounds that it might encourage moral hazard would itself be irresponsible.

That same year, however, another Nobel economist, Vernon Smith, warned that the activities of the mortgage lenders Fannie Mae and Freddie Mac were underpinned by the assumption that, as government-sponsored enterprises with lower capital requirements than private institutions, they could always look to the Federal government for assistance if an unusually high number of their clients defaulted. Both Fannie Mae and Freddie Mac, Smith noted, were always understood as “implicitly taxpayer-backed agencies.” And so it was that they continued what are now recognized as their politically driven and fiscally irresponsible lending policies until both suffered the ignominy of being placed in Federal conservatorship in September 2008.

It is curious, however, that despite the word “moral” being part of the description, Christian reflection on finance has said very little about moral hazard. A 1994 analysis of the financial sector’s effects upon the rest of the economy commissioned by the Pontifical Council for Justice and Peace, for instance, did not discuss moral hazard and how it can incentivize financial institutions to behave irresponsibly. Nor, on the other hand, does the economics literature on moral hazard contain much reflection on why the adjective “moral” is attached to the word “hazard.” If there is no moral dimension, why are these situations not simply described as instances of “risk hazard”?

It may be that the word “moral” reflects some innate, albeit largely unexpressed, awareness that there is something ethically questionable about creating situations in which people are severely tempted to make imprudent choices. To employ an analogy from Christian moral theology, the one who creates what is called “an occasion of sin” bears some indirect responsibility for the choices of the person tempted by this situation to do something imprudent or just plain wrong.

Given the truth of human fallibility, almost everyone will take excessive risks at different points in their lives. For some people, it will be with their business. Others will behave in an excessively risky manner with their own and others’ financial resources. As a consequence, some people will suffer losses.

In such circumstances, individual Christians and communities should be ready to help those in genuine need. That’s a requirement of mercy and justice. Yet Christians also can and should ask questions concerning the extent to which people have been encouraged to engage in irresponsible behavior by particular policies.

At the same time, the phenomenon of moral hazard doesn’t excuse individual and institutional financial actors from their irresponsible actions. Certainly one can be incentivized to act in a particular way, and one of the key insights of economics is that incentives matter. Christians, however, don’t believe that humans are automatons that simply react to stimuli. That means people can choose to do take reasonable rather than imprudent risks. Hence they are accountable for their actions. To deny accountability or to dismiss it in the name of people being subject to wider forces outside their control would not do justice to the Christian belief that humans are free and therefore accountable for their choices.

Image source: Pixabay

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Samuel Gregg is director of research at the Acton Institute. He has written and spoken extensively on questions of political economy, economic history, ethics in finance, and natural law theory. He has an MA in political philosophy from the University of Melbourne, and a Doctor of Philosophy degree in moral philosophy and political economy from the University of Oxford.

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