Government Bailouts and Moral Hazard

My uncle just wrote a column for the Free-Market News Network, Smaller Government Could Undermine Terrorists, in which he notes three instances in which large government has impeded effective airline security: preventing pilots from carrying firearms, preventing private security on flights, and bailing out the insurance companies who underwrote the airlines and the WTC. I would like to expand on the last point.

In a free market, insurance agencies are a powerful regulating force. In order for an agency to assume part of your risk, you generally have to prove that you are running your operation safely and effectively. If you are being slipshod and taking unnecessary risks, insurance companies will demand a higher premium, giving you a powerful incentive to improve.

One would assume that the same principle would apply to government regulations that actually make situations more dangerous; insurance companies would increase premiums in response, and the companies affected would lobby government to have the rules relaxed. But with the advent of the government bailout, the insurance companies no longer have an incentive to raise their premiums and risk losing clients. They simply continue with business as usual, and if the government regulations actually contribute to a disaster (as they did on 9/11), the insurance companies can stick government with the tab.

(One would imagine that airlines would rather pay more in premiums than risk having a plane hijacked. Unfortunately, this sort of shortsighted thinking is a constant feature of the American worldview, whether it be business, politics, or society. I don't know why it is, and I'm not sure how it could be changed without a massive cultural shift.)

In essence, by bailing out the insurance companies, the government is bribing them not to react to stupid government policies, which would in turn provoke calls for the policies to be changed. And they're doing it with our money! Pretty smooth, huh?

And they wonder why we're always complaining about taxes.