Tax Cuts and Moral Hazards

The main recipients of Bush's tax cuts are the same people responsible for the turmoil in the financial markets. The rich are so greedy that they first made bad mortgage loans to people who couldn't afford them. But the bad mortgages created "paper" that they could then sell to more unsuspecting buyers. Thus they could get the bad mortgages off their books and pass them off to someone else. It was a game of musical chairs until the music finally stopped and someone ended up holding some bad paper. Some people are going to get stuck with some losses, but others have made out like bandits and will have huge profits with which to take advantage of Bush's tax cuts, which particularly benefit those in hedge funds and private equity, some of the main villains in the bad-paper game.

In discussing what to do about this situation, the concept of "moral hazard" gets mentioned occasionally, as it does in this Financial Times editorial. The moral hazard concept is that you should not bail out people who got themselves in financial difficulty. It certainly applies to the hedge fund and private equity types; it is less clear that it applies to the average homeowner who might lose his house because he got a disadvantageous mortgage. There should be a level playing field. The hedge fund types certainly knew what they were doing; most have MBAs. Homeowners may or may not have known; they may have been cheated by mortgage brokers who didn't explain exactly what they were getting into. But the homeowners should have been smart enough to understand that if it sounds too good to be true, it's probably not true.

In any case, the moral hazard argument is that we should not bail out those who profited from taking risks that have now come home to roost. Therefore, in general, the Fed should not bail them out by cutting interest rates. But the economy does have a problem if the market turmoil threatens to bring on recession. It's the old story, "If you own the bank $100,000 and can't pay, you're in trouble. If you owe the bank $100,000,000 and can't pay, the bank is in trouble." So, it's possible the hedge fund types have the Fed over a barrel. But certainly the Fed should resist the temptation to bail out the market losers, like Jim Cramer of CNBC, according to Barrons. Bush has already given them a ton of help by cutting their taxes to almost nothing. Bush works for them; maybe Bernanke doesn't. Maybe he works for America. We'll see.