Moral Hazard & Conditionality: The Gods of this Greek Tragedy

So here it is: the long-awaited, much anticipated bail out of Greece. Was there really ever any doubt? I guess there was a little - that's why Greek bond yields went up. But the break-up of the Eurozone? Com'on - wasn't gonna happen.

So why has this been such a tragedy? Why the bickering back and forth about whether Greece will get a bail-out and who will do the bailing?

The answer has to do with "moral hazard" and "conditionality."

Moral hazard rears its ugly head any time actors are insured against a risk.

Imagine how people would drive if they were completely insured against any damage to their cars - answer: a little more recklessly.

The auto-insurance industry deals with potential moral hazard with lots of institutions: deductibles, higher premiums for folks with poor driving records, different rates for different types of cars and drivers.

Imagine the kinds of risks that banks might take if they were completely insured against risk by the government... hmmm... Imagine - it isn't hard to do.

Why, they'd take risky bets, lending to people who had little chance of repaying - and then when the loan repayments didn't come, well, they'd just get bailed out by the government.

So, how do we address this kind of moral hazard? This one is tougher. See, if the big banks fail, we all suffer. That's what "too big to fail" is all about - we don't have a credible commitment to let them fail... unless we are willing to allow the whole financial system to fail - that is, none of us eat. Since we don't want to go hungry, and the banks know this, they understand that they are just too big to fail.

Congress is trying to figure out away to deal with this moral hazard. Their solutions have to do with passing preemptive laws. One law could be to require banks to lend less and keep more money in their vaults (this is what "deleveraging" and "capitalizing" are about). Another law being considered is to keep banks small. The financial system can survive if small banks collapse. so we've got a credible commitment to let them fail. Knowing this, the small banks will not take undue risks.

Now, imagine how governments would act if they were completely insured against the risk of defaulting on loans. Why, they'd borrow and borrow and borrow... and they'd never worry about paying anything back... Yeah - imagine that. Well, this is what Germany has been imagining lately... it's been a nightmare thinking about the signal it sends when Greece is bailed out. Portugal, Spain, Italy - they'll all realize that they can borrow and spend without limit, and in the end someone will bail them out. How, then, can Germany deal with this kind of moral hazard?

The answer: Conditionality. Conditionality is just a quid pro quo. You want loans? You've got to change your ways. We'll give you a li'l slice of the loan upfront. But before giving you the next slice in a few months, we're going to check your policies. If you're still misbehaving - eating more than your earning - we'll hold up the next installment of the loan. And that will be ugly. You won't be able to pay government workers or deliver public services. Investors will run scared from your country, and no one else will be willing to lend to you. You won't eat.

Note that conditionality attacks a country's very sovereignty. The "conditions" of the loan have to do with government taxes and spending - the very essence of politics. It is as though the lender has suddenly entered into a country's political arena. And when taxes go up while spending goes down, there are lots of people who lose - people who won't be very happy about conditionality.

So who's going to impose conditionality?

Germany & the Eurozone have the money to lend to Greece. And they likely have the credibility to crack the conditionality whip. But this is dirty work. Germany would be seen as the bad guy in Greece - indeed throughout Europe - if it were dictating to the Greek government how to run Greece. If only there were some kind of smokescreen that Germany could use... where they call the shots, but make it appear that someone else is cracking the whip.

That's where the International Monetary Fund (IMF) comes in. See, the IMF has been doing conditionality for years and years. And while the United States is the largest single vote-holder at the IMF, the combined power of the Eurozone easily surpasses American might. So, the Eurozone will be calling the shots. Bickering amongst Eurozone members like France and Germany can take place behind the secret doors of the IMF Executive Boardroom. And whatever emerges will be IMF policy.

So, be on the look out for protest signs in Athens bashing the IMF in coming months. Some will surely see through the IMF facade, realizing that Germany is really calling the shots. Others will see that Greece really sacrificed its sovereignty the day they gave up the drachma in favor of the euro. But the real devil here is moral hazard. And the solution conditionality.