DEFINITION: “Moral hazard” is a form of “externality,” that is, an unintended harm suffered from a market transaction by a third entity that is not a party to the transaction.
What makes moral hazard different is that the original market transaction incentivizes the party that causes the harm to act in the same harmful manner in the future.
Also, in the case of moral hazard, the injured party may be a party to the transaction itself.
ETYMOLOGY: The word “moral” derives, via Middle English and Middle French, from the classical Latin noun mōs, mōris, meaning “will,” “mood,” “inclination,” or “custom,” and the related adjective “mōrālis,” meaning “moral” or “ethical.”
The word “hazard” derives, via Middle English, from the Middle French word hasard, which basically means “chance,” but also has a range of extended meanings, from “occasion” and “possibility” to “accident,” “danger,” “risk,” or “peril.” The Middle French word hasard, in turn, derives from the Arabic word al-zahr, meaning “dice.”
USAGE: Economic situations in which moral hazard arises are marked by what are often referred to as “perverse incentives,” that is, rational motivations supplied to one of the parties to the transaction to continue engaging in the harm-causing activity in the future.
For example, when someone purchases automobile insurance, he may drive a little less carefully, raising the probability of his having an accident due to his subjective state of mind. The harm, in this case, would fall on both the insurance policy owner and the insurer which issued the policy.
None of this means that either the harms or the incentives are intended or even conscious. The claim, rather, is that economists can successfully explain the observed economic activity arising out of such situations by invoking the concepts of externality, moral hazard, perverse incentives, and so forth.
The phrase “moral hazard” dates to the seventeenth century. It originated in the budding insurance industry of the day, which explains the connection between the term “hazard” and the notion of probability (in the sense that perverse incentives increase the probability of risky behavior).
The term “moral” had a different meaning at that time, as well, having a connotation closer to the modern concepts “subjective” and “psychological” than to the concept “ethical.”
Historically speaking, then, “moral hazard” originally meant “subjective probability.” Thus, moral hazard pointed to the fact that perverse incentives increased the subjective (psychological) probability of an economic actor’s engaging in risky behavior, that is, behavior likely to cause harm.
“Moral hazard” first became well known to the general public in the wake of the real estate bubble and subsequent financial crisis of 2008.
A part of the explanation for the bubble and the failure of many financial institutions that many economists offered at the time was that there was a widespread perception that the largest investment banks were “too big to fail,” meaning that the government would step in to bail them out if necessary.
This perception was explicitly said to cause “moral hazard” for the banks. More explicitly, critics also said that the situation effectively “privatized profit” and “socialized loss.”
This provided perverse incentives to the banks to engage in highly risky behavior—such as greatly relaxing the conditions on borrowers’ financial qualifications in order to greatly increase the number of mortgages sold.
In recent years, the phrase “moral hazard” has begun to expand beyond the bounds of academic economics into other fields of social science.
For example, today it is not unusual to encounter claims such as that relaxing conditions on receiving welfare payments produces “moral hazard,” meaning that such generosity will generate perverse incentives, which will then have the counterproductive effect of inducing more and more people to give up looking for paid work and to live from welfare.