By Ethan Hollander, Wabash College
People tend to change their behavior when they know that they’re safe from any risk of consequences for their deeds. This is called a moral hazard and governments around the world may have contributed to this with their reaction to the Great Recession of 2007 to 2009. This recession was touched off by one of the worst financial crises in history.
Too Big to Fail
At the height of the crisis, many governments proposed bailing out major banks and corporations, on the basis that they were “too big to fail”. The rationale was that these companies were so big that if they failed, the entire economy might collapse with them. Governments also passed measures to help individuals who couldn’t keep up with their mortgages.
Now, on the one hand, these measures probably helped the recovery. (They were also politically popular with the people and corporations that received the bailouts, of course.) But critics were quick to respond that programs like these risked the creation of moral hazard, where people in the future would engage in riskier behavior because they think the government will just bail them out.
Innovation Is Fueled by Risk-taking
Why not buy a bigger house than you can afford if you know that, ultimately, the taxpayer is going to pick up the bill? Why not finance risky mortgages if the government is going to step in and bail out the banks?
If people are insulated from pain, they might not try to avoid that pain as much as they otherwise would. Bank bailouts and loan forgiveness might have saved the economy, but they might also lead people to take more risks in the future.
That said, there are times when risk can be a good thing. Innovation doesn’t come about from people sitting around and doing things just as they’ve always been done. Invention, by definition, means trying something new, and so sometimes you want people to be free to take risks.
Let’s face it: The Wright brothers probably could have had a very comfortable—if uneventful—life fixing bicycles in Dayton, Ohio. But instead, they spent a lot of time and money trying to invent something new—and to invent the airplane. This was a risk, but the reward was human flight.
And, as a result, governments sometimes find themselves in the business of encouraging people to take risks. They do this by allowing businesses to form corporations. A corporation is a legal entity that separates a business from the people who own it.
This article comes directly from content in the video series Democracy and Its Alternatives. Watch it now, on Wondrium.
Walking a Thin Line
Allowing businesses to incorporate shelters entrepreneurs from risk. If you own a corporation, your liability is limited to the assets of the corporation itself—and creditors can’t come around and foreclose on your house just because your business was a failure.
Innovation and entrepreneurship are all about risk-taking: trying new things that may or may not work. And if people stood to lose everything just because they tried something new, well, fewer people would try new things in the first place.
As you can see, governments around the world walk a tightrope when it comes to the management of risk: On the one hand, incorporation encourages innovation by freeing businesspeople to take risks, but too much protection from risk encourages recklessness, which can bring an economy to ruin.
Commitment Problems
Commitment problems pit a short-term, and undeniably tempting, individual gain against something that helps society as a whole. (I might be tempted to renege on a contract, but it’s better for everyone—even me, in the long run—if I don’t.) So, we assent to the rule of an enforcer (the state) to help us out of the dilemma.
In other words, credible commitments are public goods, and in many cases, they’re public goods that almost certainly wouldn’t come about without the heavy hand of government. And this, naturally, is another source of controversy in comparative government.
Government’s Role
What commitment problems should government solve? How should it solve them? And will non-state actors step in to fill the void if government doesn’t? It’s true that, in certain circumstances, commitment problems have the potential to solve themselves.
In smaller communities, where everyone just kind of knows one another, reputation alone might be enough to allow for trust: You wouldn’t likely break your promises if word was going to spread and prevent you from being trusted in the future.
But in today’s globalized economy, reasonable people are going to disagree about when, where, and under what circumstances government regulation is required.
Some people would argue for free-market solutions to commitment problems: things that don’t require government intervention. Consumer Reports magazine and Yelp reviews encourage businesses to stand by their commitments, even in a marketplace that’s too big and anonymous for word of mouth to do the trick. And in failed states, organized crime can step in and fill the same role.
Common Questions about Risk-taking and Government’s Intervention
Many governments proposed bailing out major banks and corporations, as they believed that these companies were so big that if they failed, the whole economy might fall with them. Furthermore, they passed measures to help people who couldn’t keep up with their mortgages.
Because inventions, innovations, and entrepreneurship are all about trying new ideas. And since trying a new idea needs risk-taking, governments sometimes want people to take risks.
This has always been like walking a tightrope for governments because, on one hand, encouraging businesspeople to take risks is essential for innovation. On the other hand, too much protection from risk might encourage recklessness, which can ruin an economy.
