Debt Crisis ABCs

Debts so large that a country can’t repay them may be erased in three ways. One is a transfer of cash (a bailout), another is the purchase of the debt by the country’s central bank (printing money), the third is outright default. Most countries print money—thus to repay numerically fixed debt by cheapened money. The consequences are dire but ultimately, self-correcting. Among them is that the country’s exports, priced at inflated rates, becomes less desirable. It cannot sell its debt except at increasingly high interest rates. Eventually its currency is devalued. That in turn results in very high costs for vital imports, like oil. Money tends to flee the country, thus stifling development. Countries tend to run deficits because it is easier to increase services and to cut taxes than to tax their industry and public.

When the country is part of a larger entity, such as the European Monetary Union, the temptations remain but the painful consequences are shared by others. Members of the EMU will be inclined to use a bailout rather than suffer the consequences in an inflated Euro—and this especially if their own banks hold the bonds of the offender. Thus the first option comes into play. Some label this the moral hazard of monetary unions: incentives are present to enjoy the benefits of bestowing goods while others help with the paying of the bills.

In Europe Greece is the offender, and a Round One bailout has been approved—alongside a handful of demands for reform. Greece has not delivered on the reforms, hence Germany now opposes Round Two. And thanks no doubt to strong German signals, the European Central Bank (ECB) has drawn back from the second option, namely printing Euros with which simply to buy the outstanding debt of Greece, Spain, and Italy—thereby restoring “confidence.”

Whose confidence? Ordinary people’s? Paul Krugman’s? Krugman today vented his displeasure in the NYT with the ECB’s refusal to print money—and labeled Germany’s and others’ pressures as “moralizing.”

The moral problem that here arises is the tendency of governments to skate on the thin ice of deficit finance, hoping that the future—or more disciplined agents—will bail them out.

That in the EU individual states, like Germany and France, have to undertake bailouts (and sell them to their own people) arises from the EU’s limited powers. It’s not a nation but something short of that (see last post). Bailouts in this country are undertaken by the nation as a whole, thus by Congress. Those actions are also often dubious—the consequence of letting shady actions proliferate. Indeed the only reason why Germany and others have voted for bailouts is because they are themselves endangered by an inflating Euro if the ECB does the job instead of them.

The holders of the debt, in Greece and elsewhere, are investors, banks. They too, I suspect, winked a little when they lent to Greece, more freely surely than they should have, knowing that now, in defense of the mighty Euro, their money would be safer. Default? Everybody shudders. Ultimately it would result in a credit crisis. And if it is large enough, the walls of almighty Capitalism might begin to shake, rattle, and roll. But wouldn’t that be, like, the End of the World?

The Moral Hazards of Insurance

Wikipedia’s article on the history of insurance (here) contains a paragraph under the heading Moral Hazard in which only the risks of the insurer are mentioned. People take out fire insurance and then, later, set fire to the house to collect the insurance. Suicide and murder are committed to collect life insurance. People lie on their applications. An article in today’s New York Times on the business page, “Not All Homeowners’ Policies Are Alike,” reminded me of moral hazard once again. It can cut both ways. I’ve noticed years ago that moral hazard is a kind of center of this industry around which it necessarily rotates. Companies are very eager to sell insurance but display a marked reluctance to pay out.

The article tells of the labors of Daniel Schwarcz, a professor at the University of Minnesota Law School, to adopt uniform language in homeowners’ policies. The traditional language evidently insured the buyer against “direct physical loss to property,” but in many policies modified language has been substituted calling for “sudden and accidental direct loss to property.” Under this new clause, according to the article, a homeowner might be denied coverage of damage due to vandalism (not accidental) or the fall of an old tree (not sudden but long in coming). The companies, according to Schwarcz, are rigging the language to aid deniability—of coverage—by the ambiguities introduced by language.

My 1956 Encyclopedia Britannica tells me that fire insurance, the core of homeowners’ insurance, expanded in the twentieth century to cover damage from wind, water, and explosions. “The expansion of this branch of fire insurance company operation was particularly marked in the United States,” the EB says. Back then already. Now things are changing back—but in a fuzzy sort of way, by means of linguistic changes.

Whereas, I might here underline, the whole foundation of insurance has always been clarity. You’re either alive or dead, and life insurance doesn’t pay out when you’re simply ill. The object insured must be clearly definable: this house, this ship. Ambiguity is best left out of the policies—rather than increased by adding words the meaning of which gets rapidly foggy as soon as real dollars must be handed over.

Moral hazard is implicit in this business when those insured and those insuring are distinct and different entities. Like it or not, an insurance company’s best case scenario is one in which no losses are incurred at all. Therefore the temptation to limit payout is always present within the company—and indeed machinery is also present to keep that payout to a minimum and then, if possible, to delay that payment as long as possible. Whereas the best case for the buyer of insurance is to get paid fully for the loss, promptly, and in a sum equal to the actual replacement value of an equivalent property, in an equivalent neighborhood, today.

Insurance has always had two forms—the commercial and the mutual kind. What we have today is mostly of the former. The latter, mutual societies, once called “friendly societies” and “benevolent societies,” were owned by the members themselves. They made all of the contributions and also decided on controversial payouts. In such cases thinking up schemes under which the company can refuse full or even partial payment will not automatically benefit some bright new fellow hoping soon to become vice president.