WHILE we're thinking about ways the economics profession can improve, it's worth considering a new piece by James Surowiecki on the issue of moral hazard in government interventions. Economists, we would hope, should be able to answer a simple question and thereby clarify which of a range of policy actions is most desirable. In considering whether or not to bail-out an important financial instution, for instance, it would be nice to know whether moral hazard should be taken into account. If a rescue is likely to encourage risky behaviour, making further rescues necessary, then it may well be worth the pain to let a sinking bank fail.

While Hank Paulson has tried to create the impression that he did everything he could to save Lehman Brothers, it seems clear that officials allowed the firm to fail, in part because they wanted to send a message—don't go acting foolishly thinking everyone gets a bail-out. Paradoxically, the choice to let Lehman fail had exactly the opposite effect. The fallout from the failure essentially guaranteed that Treasury would help any other large firm in trouble.

That, of course, should have sent a message to banks that the moral hazard game was in full effect. If you know the government is standing behind you, why not roll the dice and lever up? If all goes well, then the gains you reap get you out of trouble. If all goes badly, well, you were already insolvent, and the government is there to make you whole. And yet virtually no financial institution has chosen to do this. Instead, they're taking money from the government and hoarding it.

None of this, in other words, resembles the conventional understanding of how moral hazard works. Which suggests that a serious rethink is required. Mr Surowiecki writes:

Finally, the biggest reason that moral hazard matters less than it might is that it can operate only if people actively countenance the possibility that their decisions could lead to complete disaster. But it’s well documented that people generally, and investors particularly, are overconfident and significantly underestimate the chances of being wiped out. The moral-hazard fundamentalists argue that banks and other financial institutions will act recklessly if they think they’ll be rescued in the event of failure. But Wall Street was reckless because it never believed that failure was even a possibility.

Whatever moral hazard effect is in operation, it has been swamped by adjusted expectations. Firms that thought nothing could go wrong now believe that everything can and will go wrong. And just as banks and people are radically shifting their outlooks, so too should policymakers. This doesn't mean that governments should heedlessly throw money around. It does suggest, however, that in the wake of a major negative financial or economic shock, moral hazard concerns aren't nearly as relevant as they are in more placid times. When a conflagration has burned down an entire city, the last thing one needs to worry about is whether fire insurance will encourage riskier behaviour in the future.

This calculus will change over time. After a decade or two of smooth sailing, institutions and households begin to forget the lessons of the past and adjust their expectations to discount the probability of catastrophe, which ultimately makes catastrophe more likely. This would seem to weigh against counter-cyclical policy in mild recessions. It could be that the cost of lost output is worth the effect on household expectations. Of course, it could also be that the cost of lost output is much worse than the effect on expectations. It would be nice if economists would give us better ways to think about and answer these questions.