Moral hazard occurs when someone insulated from risk behaves differently than they would behave if they were fully exposed to the risk.

An example is people who live in coastal zones where there is a high probability of a hurricane. They get insurance subsidized by the government so it is relatively less expensive to live there.

Another example is people who live in earthquake zones and don’t buy earthquake insurance because always in the past FEMA has stepped in and made almost everybody more than whole.  This example includes me.

In finance one way moral hazard occurs is that the FDIC insures $250,000 of bank deposits for individuals.  The investors then don’t have to care about safety of the bank they only have to care about yield.

Note the common thread.  The government is stepping in to try and reduce risk and by doing so promotes risky behavior.  I have written about moral hazard in the past recently about the Gulf Oil Cleanup and a few years ago about AIG bonuses.  Life is fraught with danger.  By trying to make everyone safe we create new and potentially worse dangers.

The libertarian solution is to get the government out of the risk reduction business.  The government should make sure that there is full disclosure and that widows and orphans are protected.  After that let private insurance and private transactions figure it out.  Let them fail.  Let the lawyers allocate the costs.