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Moral hazard

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The dismal science
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Economic Systems

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Major Concepts

A moral hazard is an economic situation in which certain conditions may cause one party in a transaction to take on more risk. For example, if someone insures a valuable object for its full-value, they have less incentive to prevent its theft than if the object had been left uninsured. Another example would be members of military alliances having fewer disincentives to engage in provocative behavior, knowing that their allies will protect them from any retaliatory attacks.

Moral hazards could most prominently be seen during the Great Recession, where banks would loan out large sums to people and then sell the loan obligation to someone else. As the banks were not on the hook if the person defaulted, the bankers had little reason to actually ensure that loans were only made to people likely to pay back the loans. Before the repeal of Glass-Steagall, these loans were only sold to other banks who understood this and would often use auditors when purchasing large groups of loans; after the repeal, the loans were sold to suckers who did not.