Economists have long argued that, due to moral hazard problems, that “bailing ou

Question

Economists have long argued that, due to moral hazard problems, that “bailing out” firms such as banks (the S&L crisis), brokerage firms (Bear Stearns, Drexal Burnham…) and governments may be bad idea.

Explain their difficulty with this concept of “Bail Out” in accordance with moral hazard concerns. What is the moral hazard ? What is one possible remedy for this moral hazard problem (what are the good and bad points of this remedy)?

Explain a problem “Bail Outs” create with adverse selection. What is adverse selection? What is one possible remedy for this adverse selection problem (what are the good and bad points of this remedy)?

Explanation / Answer

Both moral hazards and adverse selection tend to affect or lead to one another .let's discuss each individually

1. The difficult with the concept of "bail out " in accordance with moral hazards is that two parties might face different incentives example and insured person or entity may have less incentive to take care against risk ( a country knowing IMF will bail it out may not reduce its debt . Also another difficult is that one party involed on the bailout may have more information than the othe this leads to information assementry.

Moral hazard : is a situation where one person /entity /country takes more risks because someone else bears the costs of those risks .

A remedy for this problem is by penalise bad behaviour : example The government could bailout banks, but penalise those responsible for making the reckless decisions. In the case of Greece, bailout funds are being given very reluctantly and with conditions to reform and pursue austerity. This acts as a deterrent to those who might tame reckless risks. The bad side of this remedy is that it might result into business not taking risks hence leading to reduced investment in the economy.

2. Adverse selection is a situation where market partcipaction is affected by asymmetric information ( different levels of information is available to different parties in loved in a contract )

A remend for this adverse selection is by providing more information to all the parties. If it's on funds provide infromation about the potential fund receivers likefuture credit worthiness by looking at the past credit worthiness. The same can be done to buyers and seller's . This will help solve the problem. The bad side to this remedy is that it will be costly to implement and also providing alot of information might hurt some sectors in the economy or businesses

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