Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Fixing the Financial System without Solving Moral Hazard Is Impossible

The financial system has serious problems (but unless you’ve been living under a rock for the last eight years, you know that!). The problem of systemic risk (if one large bank fails, many banks may fail) means that financial institutions (especially large ones) face a moral hazard problem: they have incentives to take on excessive risk in the knowledge that governments are likely to bail them out if things go pear-shaped.

Without solving the moral hazard problem, fixing the financial system is impossible. Unfortunately, it’s a very difficult problem. A number of solutions have been proposed, including these two:

Breaking up large banks: The idea is to reduce systemic risk so that governments can commit credibly not to bail out a failing bank. If a bank goes under, so be it. The hope is that, with this knowledge, the bank itself doesn’t want to take on excessive risk.

Forcing banks to take less risk: Introducing regulations, such as requiring banks to hold a greater proportion of their deposits in reserve. The idea is that this will substantially reduce the probability of a bank failure.


Recognising that, Ultimately, Real Things Are What Count

This point is especially important. People shouldn’t care about nominal things – they should care about real things. Here are some examples:

Real wage: What really matters about your wage is how much stuff you can buy with it, not its numerical value. So if your boss offers you a 5-per cent pay rise when inflation is running at 10 per cent, you’re getting a raw deal: your real pay will fall by 5 per cent.


Real interest rate: When you’re borrowing (or saving), the real interest rate is what matters, not the nominal interest rate, because the real interest rate tells you the cost of borrowing in terms of goods, not in terms of money. Money is useful only for buying goods, and so this is what counts.

Real Gross Domestic Product (GDP): The value of goods and services produced in a country rises over time due to inflation, even if the total quantity and quality of those goods are unchanged. Saying that this situation represents an increase in a nation’s productive capacity or its living standards would be silly. Therefore, macroeconomists focus on real GDP (that is, GDP adjusted for the effects of inflation). Chapter 4 has all the gen on GDP.