One cannot fully understand how the free market works without understanding a concept called, ‘Moral Hazard.’ Moral Hazard, “is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.” (Wikipedia)

The simplest example of Moral Hazard is a teenager who takes greater risks because he or she knows his/her parents are around and, therefore, is not exposed to the full consequences of his/her actions.

How does this apply to the free market? Because freedom DOES NOT exist without consequences. Take away consequences and you have no freedom at all. A friend of mine, Tom Phillips, said wisely, “People think that capitalism is a for-profit system. It is not...it is a profit and loss system. Profit encourages risk and loss encourages prudence.”

The government believes that people or institutions should not be exposed to risk or consequences. “It is not right,” “They cannot be trusted,” “We need safety nets” are some of the arguments for eliminating consequences. However, the flaw in this argument is that consequences exist, whether you try and take them away or not, and if a person is under the ILLUSION that they have no consequences they will take greater risk and endanger themselves and the system even more.

One example is the FDIC. The FDIC was created and implemented as part of the New Deal by FDR as a way of insuring deposits. The problem is banks took greater risks because they believed the FDIC would bail them out. However, because of the mortgage/credit crisis, the FDIC is failing to meet its required statutory minimum of 1.15% of capital per insured capital per insured dollar deposits. As a result, it is running to the  Treasury to support it with taxpayer or printed dollars.

Another example of ‘moral hazard’ is the Community Reinvestment Act, started by Jimmy Carter in 1977 and strengthened by Bill Clinton in 1995. Banks were told to make loans to risky borrowers who could not afford them and they did so because they believed that the government and Fannie Mae and Freddie Mac would underwrite or basically subsidize the risk. I do not have to tell you how that story is ending.

Moral Hazard does not only apply to finance. It also applies to crime, personal life decisions, safety and warfare. We all wish we could ‘rock and roll all night...and party every day,” but there are consequences to everything. Its important for the government to understand that we need consequences to keep us self-policing, safe and prosperous...so that at least we can afford to party on the weekends.