One of the great things about economics is that so many ideas that are central to our discipline are easily seen in both the most mundane and most exotic of places. Today’s illustration of economic principles comes to us from the National Football League.
One of this week’s lead stories at CNN.com was about the rash of violent injuries involving helmet hits in last weekend’s slate of NFL games. Several players were seriously hurt after helmet-to-helmet or helmet-to-body collisions. The league and fans are worried that someone will be permanently paralyzed and are looking to adjust the rules and increase the fines to discourage using helmets as the lead tackling device.
None of the pieces I’ve read has pointed out is that the very safety created by advances in helmet technology and other padding and protection bears some responsibility for the problem. Why is that? Well, if a player wears a very lightweight helmet that effectively protects him from injury, he is more likely to take risks with his head than otherwise. Safer helmets lower the risk of using them dangerously. To see this, try imagining the football players of 75 years ago, with their leather helmets, doing what modern players do. If your head isn’t protected, you’re not going to use it as a weapon.
This, of course, is a textbook example of what economists call “moral hazard.” That’s a situation in which insuring against a bad outcome leads to more of that outcome precisely because the insured expects the consequences to be less severe than they would have been without the insurance. For example, car insurance leads to more accidents, and health insurance leads to people being less careful about their health. In both cases the fact that one is insured against a bad outcome leads one, at least on the margin, to take more risks that might produce the outcome in question. (Do mandatory motorcycle and bike helmet laws lead riders to take more chances and actually cause more accidents? Do seatbelts have the same effect?)
Before we go too far with this, we also need to recognize that the moral hazard problem can be overcome, at least to some degree. In the case of auto insurance, we try to overcome it by using various proxies for the likelihood that a given driver will drive recklessly and charge riskier people higher premiums. Hence young people pay more than middle-aged people, and men generally pay more than women. Certain safety devices on the car also get owners discounts (although that may encourage some risks). Deductibles are also intended to reduce risky behavior.
Similarly, owners of homes with security systems get discounts on homeowner’s insurance. When the insurer can adjust premiums to match the riskiness of the insured, moral hazard is reduced (though not eliminated). But when the insurer either cannot or does not attempt to adjust for risk, the moral hazard problem is in full force and we are likely to get a lot of risky behavior.
Moral hazard was a key part of the boom that produced our current recession. It was relevant in at least two places. First, banks have long been covered by federal deposit insurance, which produces a significant moral hazard. The FDIC promises to bail out a bank’s depositors if it fails, but does not charge banks a high enough premium to discourage risky behavior. No bank wants to fail, but on the margin, knowing your depositors are insured by the federal government means you can take risks you otherwise wouldn’t take. And banks surely did.
Fannie Mae and Freddie Mac used the implicit promise of a taxpayer bailout in much the same way. Knowing that if their mortgage and mortgage-backed securities holdings collapsed they would get an infusion of tax dollars, and having access to special credit lines at the Treasury, they certainly took risks they wouldn’t have taken otherwise. The result, of course, was mortgages given to people who never should have had them and the creation of financial derivatives that were ultimately unsustainable.
Bailing out banks and financial institutions during the crisis makes the moral hazard problem even worse down the road because they have every reason to think they will be bailed out again, encouraging them to pay even less attention to their risky choices.
Like our football players who by trying to protect their heads end up with concussions and broken limbs, many of our financial institutions are on the injured reserve list, with the result that the economy is faltering. The lessons to be learned from football helmets are that attempts to reduce risk can themselves create it and that correctly pricing risk is crucial to keeping an economy healthy.