Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk.
In economics the notion of moral hazard has always been something I have found difficult to explain/teach. In the English language moral hazard has an amusing double meaning. It is almost akin to giving an alcoholic a drink. It would be interesting to get a translation of this phrase into other languages. In the last month I wrote a hypothetical letter to my 16 year old self (there is a popular book where a number of celebrities have done the same thing; it was a present for my sons 16th birthday). This hypothetical letter was plagued with moral hazard. I am 50 now and therefore have none of the dangers that would have inflicted my younger self.
In my letter I talked about how much I enjoyed my time in Africa, now over 30 years ago. In reality, when I was actually there I was constantly aware of an omnipresent threat of danger that may have manifested itself. At the time I was not insulated from dangers and was fully exposed to any risk. In retrospect the experience was wonderful to look back on. Such are the luxuries of being excluded from risk. Clearly afterwards I remained perfectly safe.
It is only recently, where there have been a number of classic examples of moral hazard, where it is easier to give an example of what the phrase moral hazard means. Most recently in 2008 when the banking crisis started, and the Northern Rock bank in Britain provided bank accounts/loans to those individuals with less secure incomes. This situation is reminiscent of the sub prime market in the United States where bankers exploited new risks by exposing the less well off to house purchase. When these less secure loans began to collapse it initiated a global banking crisis. In Britain the example started with the Northern Rock bank, the illustration of moral hazard was given by the governments underwriting of these more marginal accounts/loans. The security that this governmental underwriting of these more riskier loans prompted the hazard of lending to these less prosperous individuals.
Throughout the world we now have a global debt crisis where the very security of banking depends on this so called lender of the last resort. A lender of last resort is an institution willing to extend credit when no one else will. Originally the term referred to a reserve financial institution, most often the central bank of a country, that secured well-connected banks and other institutions that are too-big-to-fail against bankruptcy. Ultimately here the lender of the last resort would be the world bank or the IMF (International Monetary Fund) who are underwritten essentially by the United States.
Another example of moral hazard is represented by the European community. Within the EU a number of separate states have combined together to enjoy a common currency known as the Euro. The main bank or the main lender of last resort here will be Germany/France. A number of countries within the EU, all of which enjoy using the Euro, are experiencing problems relating to their collective debt crisis. Most particularly Greece, Spain, Portugal, the Irish Republic and more recently the experience of Italy where public debt has become an issue. The Irish Republic have given dutiful attention to their moral hazard problems by cutting public expenditure resulting in the reduction of their outstanding debt. Greece however, has been allegedly more remiss.
It is unlikely that the EU, collectively, will allow the Euro to fail. The classic moral hazard problem is there are a number of separate countries sharing the same currency. To reiterate: Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk. In such a case we are unsure ultimately what organisation represents the lender of the last resort. Although Britain has remained beyond the use of the euro, the global banking crisis remains an issue.