Monday, January 28, 2008

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently to the other party's peril. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlords require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than he or it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions.
Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me for the true risk of my living less the actuarial tables predict.
In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's managers do?

They note that if the bank can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.
The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from the new loans to get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for higher interest, but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off even if the loans go sour.

Neither the the bank nor the depositors are behaving the way they would in the absence of deposit insurance. That is the essence of moral hazard.

Wednesday, January 09, 2008

Wichita's Unemployment Rate is 3.9%

The Bureau of Labor Statistics announced that the unemployment rate in Wichita was 3.9 percent in November. This comes after Friday's report that the national unemployment rate rose to 5.0 percent in December. Although Wichita's November unemployment rate was up from October, I believe the rate reported for October was low due to sampling error.

While the national economy has slid into an economic recession, Wichita's economy led by aerospace and natural resources continues to grow. The number of jobs grew 3.9 percent over November, 2006.

Monday, January 07, 2008

Are We In A Recession?

[Graph courtesy of the federal Reserve Bank of St. Louis. Click on the graph, to enlarge it.]

The employment report issued by the Bureau of Labor Statistics (BLS) on Friday sent the stock market down by 250 points. Although employment as measured by firms' payrolls rose, there was virtually no growth over November and the unemployment rate jumped to 5.0 percent (from 4.7 percent.)

Few are saying we are already in a recession, but more are thinking the danger is increasing. Look closer, particularly at the unemployment data: they are a real worry!

There are two separate surveys the BLS uses to gauge the strength of labor markets: the establishment survey and the household survey. For the establishment survey, firms are asked how many employees they have on their rolls. In the household survey, households are contacted and asked who is working and who is looking for work. In recent years cyclical analysts have largely ignored the household survey for two reasons. The month to month noise in the household survey is greater. Secondly, the population controls for the survey from the Census Bureau distorted the time series in the early years of the decade.

Ignoring the household survey is a big mistake. Right now it is giving off strong signals that we are already in a recession.

The unemployment rate has risen from 4.4 percent in March to 5.0 percent in December. Although the drop in November and the jump in December were noise associated with an early Thanksgiving, a decline of six tenths of a percent over nine months is not noise! It is difficult to find a comparable rise that was not part of an economic contraction.

Total unemployed have risen by almost a million (917,000) since March. See the attached graph. Although the population benchmarks through off comparisons in the number of unemployed from one year to the next, they do not affect the measured change from March to December.

A positive note for Wichita's economy, employment in transportation equipment other than cars and trucks continued to rise.