Moral Hazard is a term used by economists to denote situation where people have no risk in an action. For example, let us say you have no deductible for auto insurance and no penalty for behavior. You are more likely to undergo risky activity than otherwise. Companies are likewise. If I know my parents will bail me out, buy me a new car, repair my old one, and not dock me for it, I am more inclined to engage in higher risk activities than if I had to pay so myself.
This week, the Fed cut the discount rate a half point to provide market stability as a result of the sub prime mortgage crisis. I do not believe they should have done so. They are creating a moral hazard for those firms who participated in risky behavior and have now set a bad precedent: go ahead and go for the high risk high payout situations and if problems occur, we will bail you out. Firms, like people, need to know they must pay the piper for their bad decisions.
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