If Coronavirus has taught Wall Street anything, it is that it will always have a friend in the Federal Reserve – like a Randy Newman tune. The central bank might be shy and coy at first, but the chief occupants of the Eccles Building will always open their arms and give the bulls and bears a big hug. The Fed is bailing out The Street like nobody’s business. However, this unprecedented multi-trillion-dollar tsunami of money-printing will lead to unintended consequences and moral hazards, igniting a highly flammable mixture of irresponsibility and distortions never seen before in the open market. Will this firestorm burn the entire economic system to the ground, or will it just add more lacerations to a burned corpse?
Moral Hazard: A Primer
In economics, a moral hazard is when a party participates in a risky event, confident that it is shielded against the risks since the other party will bear the costs. The Government is spending like sailors who got drunk on cheap hooch on their maiden voyages, only to get bailed out by the Fed acquiring Treasurys. Too-big-to-fail financial institutions are permitted to play craps, blackjack, and baccarat since they will, in the end, be bailed out by taxpayers. Mortgage lenders pushed to approve applications from subprime borrowers because the funding is guaranteed by Fannie Mae, Freddie Mac, Congress, and the Fed.
Legendary economist Friedrich Hayek contended that the creation of the Federal Reserve System was the premier example of moral hazard in the finance industry. Since the intent of the central bank is to mitigate a financial crisis by rescuing banking entities from liquidity mishaps, acting as the lender of last resort, commercial banks are incentivized to extend vast sums of credit. He posited that in a central bank-free economy, excessive credit creation is restrained by fear of failure.
Hayek wrote in a 1925 article, entitled “Monetary Policy in the United States After the Recovery from the Crisis of 1920”:
“It cannot be taken for granted that a central banking system is better suited to prevent disturbances in the economy stemming from excessive variations in the volume of available bank credit than a system of independent and self-reliant commercial banks run on purely private enterprise (liquidity, profitability) lines.
“In the absence of any central bank, the strongest restraint on individual banks against extending excessive credit in the rising phase of economic activity is the need to maintain sufficient liquidity to face the demands of a period of tight money from their own resources.”
What Fed Chair Jerome Powell is doing today will spawn moral hazards that are as toxic as the waste found at a nuclear power plant – or in the Swamp.