Risk Externalization is Moral Hazard

Wed, Mar 30, 2011 - 8:42am

In recent years, several large man-made disasters have been witnessed with widely felt negative effects due to the externalization of risk by entities claiming limited liability. The concept of limited liability was engineered to protect businesses from losing more than all of their capital, but it is now being abused by corporations and governments who use it to externalize excessive risk. The net effect in a financial model is to convert a natural forward contract into a call option for the risk taker. The profits are kept by the risk takers. However, when risk is externalized, the losses are realized by innocent bystanders. This is the definition of moral hazard.

The pattern has become so great, and so prevalent that entire civilizations are now at risk of severe alterations. While limited liability may be necessary to protect businesses and entrepreneurs, risk assessments be should made for worst case scenario outcomes, however improbable, and risk taking entities should be forced to insure or reinsure externalized risks. In a financial model, this would be the equivalent of purchasing a put option for externalized liabilities. The cost of insuring should be considered in profit and loss projections for risk taking entities, not externalized.

The cost of BP’s oil spill is still being added especially now that criminal charges have been made. However the cleanup cost was recently estimated at $42 billion, excluding further litigation claims. While BP is paying a share of the cost, the question remains as to whether the Gulf of Mexico could ever be properly cleaned up and business owners fisherman, and others impacted are every properly compensated.

The Fukushima nuclear plant in Japan was required to carry $1.5 billion in insurance. However, the insurance doesn’t cover natural disasters even though the site is on the ocean shore over a known fault line. The Japanese government will pass the cleanup costs onto its taxpayers. The cost could be more than $300 billion and take decades. In the US, the nuclear industry maintains a $12 billion reinsurance fund. However, analysts estimate that if a nuclear meltdown occurred at the Indian Point station north of New York City, it could make the city inhabitable for years and cleanup costs could range from $720 billion to $1 trillion or more.

While the Fukushima disaster costs are unimaginably high, nothing compares to the risk externalization of financial products which have been monetized by the US government since 2008. Gross Federal debt has increased by roughly $4 trillion, and the Federal Reserve balance sheet has increased by almost $2 trillion. Other costs that are harder to measure include the loss of interest income due to zero percent interest rates, and the loss of purchasing power due to the fall in the value of the dollar.

With the onset of peak oil, and continuation of globalization, some risks taking is necessary to meet global energy demand. Nuclear plants, and deep water drilling may be part of the solution, however the true risks should be insured. Likewise, financial risk takers and governments should not accept excessive risks without purchasing proper insurance. If the costs are prohibitive then they aren’t economical in the first place. The real risk is moral hazard itself.

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