How does TARP illustrate the problem of moral hazard?

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pohnpei397 eNotes educator| Certified Educator

The Troubled Asset Relief Program (TARP), passed by Congress in 2008, was an example of moral hazard because it essentially bailed out companies that had made bad investments.

The term “moral hazard” refers to a situation in which someone is inclined to make risky decisions because they are not the ones who are going to bear the costs if their decision turns out to be the wrong one.  For example, let us say that you ask me, for some reason, to take $1,000 of your money and gamble with it.  Perhaps you say that we will share whatever I win.  There is moral hazard here because I know that I will not really be harmed if I lose the money.   I might be inclined to make risky bets because I can make a lot of money if I win and I don’t really lose anything if I don’t win.

This is essentially what the TARP allowed companies to do.  Companies in the financial sector had made many bad decisions with regard to investing.  When the financial crisis broke out, they were facing huge losses.  But then the government created the TARP and protected them from bearing those losses.  This creates a system of moral hazard because the companies and others like them will figure that they are “too big to fail.”  They will go on making risky bets because they figure that they will be bailed out if their bets go bad.