Larry Murphy: Hall of Famer, Champion, Economist?

Over his NHL career, Hall of Fame defenseman Larry Murphy was praised for his reliable defense, gifted offense, and his immense hockey skill. But until now, I doubt he has been lauded for his economic insight. Perhaps even Murphy is unaware that his recent comments about head injuries in the NHL perfectly illustrate a real-world example of moral hazard. Speaking to an NHL.com reporter, Murphy explained current players rely on referees rather than their own decisions to keep them safe on the ice. "You always had to be aware of where you are in relation to the boards and you had to stay close to the boards and protect yourself that way," Murphy said. "Now the play is to turn your back to a guy and it's like, hands off.” While it may appear that Murphy was simply talking about how his sport has changed, his logic rests on the same clear principles economists use when analyzing many situations with the concept of moral hazard.

First, let’s start with a bit of back-story for those not familiar with hockey. The rules of the game allow for a great deal of contact, called checking, during play on the ice. Legally, only the player who controls the puck can be checked, and contact is allowed anywhere on the ice, even near the boards. As modern medical understandings of head injuries and long-term brain damage have advanced, the hockey community, and specifically the NHL, has made efforts to further protect its players. In the past three seasons, a large emphasis in rule enforcement has been made to prevent hits from behind that would send a player head-first into the boards without warning. There is no debate in my eyes that the intent of this policy should be supported in every way. The economics in all this stems from the fact that players have begun to play the game differently due to a change in incentives.

Murphy outlined how current players now take a more aggressive position on the ice because they no longer have to protect themselves; rather, the players know that the referees will protect them by calling penalties. From an economic standpoint, defensemen now face different incentives than they did before the rule change occurred. The risks associated with being hit from behind can be viewed as the cost associated with turning around on the ice. Since the new rules make those dangerous hits less likely, they essentially lower the cost defensemen face when deciding if they should put themselves in a vulnerable position. Economists refer to a moral hazard as any time a change in the larger economic system designed to protect an individual causes that person to alter his behavior to be more risky.

Perhaps the most vivid illustration of moral hazard comes from a quip by an economist who realized that as safety features in automobiles have advanced, so have the number of accidents. He stated that technological advances that have reduced the number of fatal car accidents in the country (e.g. airbags, seatbelts, etc.) would be just as successful as removing all safety features from a car and installing a giant metal spike in the center of the steering wheel that would be sure to impale the driver even in a minor crash. While the comment is tongue in cheek, its underlying point is very valid. Consider if this alternate proposal were true. I imagine that drivers would be much more attentive when driving and make many more efforts to drive safely, such as reducing their speed and avoiding distractions like cell phones. Whether talking about new rules on the ice or safety changes on the road, the theme is the same: as technology changes the rules of the game to make people safer, they will respond by worrying less about risks and engage in more dangerous behavior.

Discussion Questions:

1. Suppose the NHL is unhappy with the change in the style of play that has occurred since hits from behind have been more carefully officiated. What sort of rules or incentives could they introduce to continue to keep protecting players, but return play to the way it was before?

2. Consider the following scenario: A baseball pitcher is traded in the middle of the season. His previous team was the worst defensive team in the league. However, now he has been traded to the team with the best defensive players. In his first start for his new team, his coaches are baffled when he starts throwing many more aggressive and risky pitches that could be hit into play. How would you explain the change in the pitcher’s behavior to his coaches? What would you suggest they do if they want him to continue to pitch the way he did for his previous team?

3. Suppose the U.S. government passes new legislation that provides free healthcare to everyone in the country. As an economist, apply the principle of moral hazard to predict what will happen to the number of doctor visits that patients choose to make in a year.

The Fed's Rate Cut

As Greg Mankiw recently pointed out and Wall Street Journal reporter David Wessel was quick to observe nearly a month ago, the actual federal funds rate has been trading below the Fed's target federal funds rate of 5.25%. The federal funds rate is the rate at which banks borrow from one another overnight, and it is the key benchmark interest rate for monetary policy. The Fed targets a relatively low, or loose, fed funds rate in order to encourage borrowing, speed up economic growth, and avoid recession. The Fed targets a neutral rate when it wants neither slower nor faster growth than the economy is currently experiencing. The Fed targets a relatively high, or tight, rate when it wants to discourage some borrowing, slow the pace of economic growth, and ensure price stability (low and stable inflation).

According to Mankiw, the actual fed funds rate averaged 5.02% during August—23 basis points lower than the target—while in the preceding 13 months, the Fed had never allowed the actual rate to deviate from the target by more than 1 basis point. Although we can't be sure until the next Federal Open Market Committee (FOMC) meeting on Tuesday, September 18, the behavior of the actual rate in August seems to suggest that the Fed will cut the target federal funds rate to at least 5.0%. A rate cut would mean that the Fed is backing away from a tighter policy stance associated with reducing inflation, and moving instead toward a more neutral monetary policy that will allow it to wait and see how the recent subprime and housing-market turmoil plays out in the broader economy.

The prospect of a rate cut raises the issue of moral hazard. Some critics feel that any loosening by the Fed will bail out borrowers who have taken on risky subprime mortgages and investors who have purchased the assets backed by such mortgages. By cutting rates, the Fed may encourage borrowers, lenders, and investors to make similar gambles in the future on the assumption that the Fed will intervene if things turn sour. Tyler Cowen's latest New York Times column argues that while the Fed should not go out of its way to help poor decision makers, the Fed's mandate—price stability and full employment—should not be sacrificed for fear of instigating moral hazard.

Discussion Questions

1. If banks become increasingly reluctant to lend to one another and to individual borrowers, what will happen to the types of consumption and investment expenditures that are typically financed by borrowing?

2. If borrowing difficulties persist for an extended period of time, what would you expect to happen to housing prices? What about economic growth? How should the Fed respond to this type of credit crunch?

3. Consider the borrowers, lenders, and investors who made poor decisions in the subprime market. Will some of them benefit from an FOMC decision to cut rates? Can the Fed prevent all moral hazard associated with monetary policy decisions? Can Fed policy provide total relief to the borrowers, lenders, and investors who made poor decisions in the subprime markets?

Lender of Last Resort

Rising foreclosures among homeowners with subprime mortgages led to unusually tight credit conditions in the banking system last week. Banks became reluctant to provide routine short-term loans to one another for fear that a borrowing bank's balance sheet would be too heavily concentrated in shaky subprime loans. When banks are reluctant to lend to each other, they tend to make fewer loans to businesses and households. Liquidity—the ease with which banks lend to creditworthy costumers and institutions—began to dry up. On August 17, the Fed entered the fray.

In two press releases (here and here), the Fed acknowledged that recent reluctance to lend posed a threat to economic growth, and in a rare move, it encouraged banks with limited credit access to borrow directly from the Fed by lowering the discount rate. The discount rate is the interest rate at which banks borrow from the Fed. The Fed typically sets the discount rate 100 basis points (1 percentage point) above the rate at which banks lend to one another (the federal funds rate). On August 17, the Fed narrowed the spread between the discount and federal funds rates to 50 basis points—thereby reducing the penalty associated with borrowing from the Fed.

By lowering the discount rate, the Fed was fulfilling its function as the lender of last resort. To see why the Fed stepped in, it helps to consider how subprime fears might affect the availability of loans for creditworthy borrowers. Banks, especially large ones, often borrow in order to meet the Fed's reserve requirement (the fraction of the bank's deposits that must be held in reserve rather than being lent out). Without knowledge of which big banks will be affected by subprime foreclosures, other banks that would typically lend some of their excess reserves to big banks at the federal funds rate will be reluctant to do so. If large banks that are short on required reserves find it difficult to borrow reserves in the federal funds market, they will be forced to call in loans, and they'll be hesitant to make any further loans. If banks call in loans and hesitate to lend to even creditworthy people and businesses, loan-dependent consumption and investment spending will fall, leading to slower economic growth, or worse, recession.

By reducing the discount rate, the Fed hopes to increase liquidity in financial markets by making it easier for banks to obtain short-term loans. If the policy works, creditworthy borrowers will not have any trouble obtaining loans for houses, cars, factory expansions, office buildings, and the like. As the subprime crisis subsides, regular credit conditions should prevail and the Fed will be able to return the spread between the federal funds rate and discount rate to its initial value of 100 basis points. If the credit crisis persists in spite of the discount rate move, the Fed will have to take stronger action. Read a recent Bloomberg column by John Berry to find out more.

Discussion Questions

1. In times of financial crisis, the Fed functions as a lender of last resort. More typically, the Fed's role is one of economic stabilization—maintaining low and stable inflation as well as full-employment output. How does the Fed's discount rate decision help it to fulfill its roles as lender of last resort and economic stabilizer?

2. Berry's column mentions "moral hazard" several times. In what way does the Fed's discount rate decision risk moral hazard?

3. Fears about losses from assets backed by subprime mortgages were at the root of much of the financial turmoil of recent weeks. According to Berry's column, how do the estimated losses from the default of subprime borrowers compare to the total assets of the U.S. and Euro-area banking sectors?

4. If the credit crisis continues and economic growth suffers, how might the Fed respond?

5. According to Berry, "…growth may have been damaged even if [credit] markets do settle down relatively soon." How would a temporary credit crisis damage economic growth? Consider the links between lending, housing prices, household wealth, and consumption, as well as the link between lending and investment.

Bring Back the Draft?

During the 1960s and early 70s, economists--including Milton Friedman of the University of Chicago--made a strong case for ending the draft, the government practice of forcing people to join the military. Those who supported the draft at the time argued that an all-volunteer military would be far too expensive. Eliminating conscription would force the military to pay higher wages in order to attract young men. Higher pay would cripple the military, especially during Vietnam.

The response from Friedman and other draft opponents? Sure, the draft lowers the budgetary cost of building up a military, but only at a massive opportunity cost. Those who join the military because of the draft or the fear of being drafted do so against their will. Most draftees (if not entirely opposed to military service) would require a higher level of pay in order to enlist as a true volunteer. Conscription forces people into service at lower pay than they would otherwise earn. That is, draftees pay a conscription "tax" in order to finance the nation's military build-up. The conscription tax is equal to the difference between the pay draftees would earn in the absence of the draft and the military pay they earn because of it. Better, according to Friedman, to abolish the draft altogether and have all tax payers bear the costs of maintaining an army of soldiers who voluntarily accept their posts and pay.

Draft opponents won the day Congress allowed the law authorizing the draft to expire on June, 30 1973. Why, then, is Charles Wheelan--another University of Chicago economist--calling for a return to conscription? Read his latest Yahoo! Finance column to find out.

As Wheelan points out, moral hazard occurs when people behave differently--and sometimes recklessly--because they don't bear the full costs of their actions. Mountain climbers may take riskier routes because they know there's a good chance search and rescue can find them if they get stranded. Insured drivers may exercise less caution because their policy reduces the cost of getting in an accident. Auto insurers address moral hazard by requiring deductibles--a sum that the driver must pay on a claim before the insurance kicks in. If drivers understand that they'll pay the first $1,000 for any damages from an accident, they may drive a bit more cautiously.

Wheelan applies this theory to U.S. foreign policy, arguing that an unintended consequence of the all-volunteer army is that it makes the electorate more likely to support U.S. military involvement in overseas conflicts.

1. Wheelan proposes a modified draft. In what ways is his proposal like the deductible on your auto insurance policy? Do we need another conscription tax to put a check on our troop commitments in times of humanitarian crisis?

2. How is deficit financing (issuing government bonds instead of collecting taxes) like the moral hazard problem surrounding foreign intervention and invasion by the U.S. military?

3. In what way is Wheelan's proposal subject to the same criticism Friedman leveled against the draft nearly 40 years ago?

4. Despite enlistment bonuses and aggressive recruiting, the U.S. military has had difficulty increasing manpower during the Iraq war. Politicians and the electorate cannot decide to invade or intervene if would-be soldiers won't enlist. Do you think the free market for military labor that Friedman championed provides enough of a check on the moral hazard of a volunteer army? Or do you agree with Wheelan that some form of conscription is needed to discourage hazardous decision making?

To read more about the role economists played in ending the draft, click here.