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Moral hazard and state lockdown restrictions: A self-inflicted wound?

June 2, 2020

The term “moral hazard” refers to the tendency for insured parties to take more risk after they have insurance. The insurance industry has also made a distinction between “morale” and a stricter “moral” hazard, the former being a simple tendency to take more risk, and the latter being cases where the insured party may actually have an incentive to cause the loss for which they purchased insurance. In this context, moral hazard has sometimes been described as “a $5,000 garage rubbing up against a $10,000 fire insurance policy.”

Moral hazard issues drive concern about the public “safety net” for our banking system and financial markets. Deposit insurance, the Federal Reserve’s discount window, payment system guarantees and other tools advertised to stabilize the system can actually spark more risk taking, and arguably cause instability. The morale vs. moral hazard distinction can become important if market participants try to game the system and take big risks, so long as any gains can be privatized while losses are socialized. Moral hazard concerns become more acute the closer to insolvency a financial institution becomes, as “zombie” institutions with little to lose and much to gain take higher risks.

This perspective can inform public policy issues relating to public sector pensions. Many of them are dramatically underfunded and arguably insolvent, even as they continue to survive on a cash flow basis. High discount rates and aggressively risky investment portfolios may well be part of the morale hazard problem, particularly in states with stronger legal guarantees for public sector retirement benefits.

But here’s a speculation about an issue for moral hazard, not morale hazard, arising from recent events.

WalletHub recently released a study ranking the states on how severe their lockdown restrictions have been, since the onset of the coronavirus crisis. Looking across the 48 continental United States, there is a remarkably strong correlation with Truth in Accounting’s “Taxpayer Burden” measure of state financial conditions. States in better financial shape tend to have fewer restrictions, and troubled states tend to have more restrictions. In turn, a simple regression explaining state rankings on lockdown restrictions suggests unfunded retirement benefits and the share of the public workforce covered by collective bargaining agreements have significant relationships with how severe those restrictions are. More intensively unionized states tend to have more lockdown restrictions, even after controlling for how underfunded their retirement benefit plans are.

Those lockdown restrictions have had economic consequences, including consequences for general tax revenue. Why might states in the worst financial shape be working harder to slow down their economies right now? 

Granted, correlation is not causation. States in bad financial condition also tend to be more congested, with higher urban populations. If lockdowns make sense, this may not be such a bad moral hazard problem.

But state and local governments in bad financial condition, and their friends in financial markets, might also be doing their best to impress the “guardians” of our federal fiscal purse how bad things are, with a view to getting bigger bailout packages. And the wounds may not be so self-inflicted, if some of the people paying the price right now are out in the streets, while taxpayers more generally pay a price in the future.

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