Moral Hazard and Regulation

There is a lot of speculation in the blogosphere that the housing market is overheated. I blogged about it here. Half Sigma did here and here. Coyote Blog did here and here.

My guess is that many of the big lenders are basically ignoring the possibility that some major event, like a big rise in interest rates, will trigger a major housing market collapse and bankruptcy for both homeowners and the lenders. Perhaps one of the reasons that lenders are discounting this possibility is that in the past, the government has bailed out industries that got themselves into trouble in the past. “Too big to fail” is what you think about when you hear of the lending giants Freddie Mac and Fannie Mae.

Intuitively, we know that the government should not treat big corporations differently that the little donut shops. But if the government has bailed out the Airline Industry, then it is reasonable for other big corporations to believe that the government will not just sit back if a major collapse occurs. The government cannot credibly signal that it would never bail out another major corporation again.

This raises an interesting policy question: should the government allow laissez faire market economics and risk a major – perhaps catastrophic – miscalculation on the part of industry because we know that is the right course in the long run, or should it regulate the industry to avoid moral hazard?