Yesterday’s Wall Street rally was indicative of a world investment community desperate for a shred of good news. The U.S. employment figures were better than expected and a consortium of central banks, the Fed included, agreed to prop up European banks with temporary funding.
Everyone now knows the meaning of “moral hazard” – a term foreign to the business vocabulary twenty years ago. It first came to the fore with the Asian Crisis of the summer of 1997. Buyers of bonds of the emerging Asian economies, expecting a lender of last resort, sought to profit from high interest Asian bonds and fixed dollar exchange rates. The two most recent episodes of moral hazard are the U.S. mortgage disaster and the toxic debt of Ireland, Greece, Portugal, and now Italy. In both cases, investments were made assuming a lender of last resort. Things are different from 1997: We have no credible lenders of last resort who can make whole creditors who stand to lose not billions but trillions.
Moral hazard and lenders of last resort are addictions. We realize their costs only after the fact, and then we must agree to yet another bailout. Otherwise the costs are too high.