Moral hazard is the term for what occurs when one shelters an entity from the full cost or downside of taking risks. The result is that the entity will tend to take on more risk than it would have had it had to bear the full costs. For example, if a company knows that the government will make up the shortfall if its pension investments suffer, it will tend to invest in high-risk, high-return investments that reduce the company's need to contribute funds in the good years. This is sometimes called privitizing profits and socializing losses.
One of the problems with demonstrating moral hazard is that the hazard often occurs years after the action (usually a government action) that creates the hazard. But this week we have an amazing opportunity to see moral hazard operating within days of a government bailout:
Immediately after GMAC became eligible for TARP money, GM reduced to zero the interest rate"¦ on certain models. This, of course, penalizes GM competitors, including Toyota, Honda and other "transplants" whose cars are made in America by Americans for Americans, and Ford, which does not have the freedom of maneuver conferred by TARP money because Ford is not taking any"¦
GMAC has begun making loans to borrowers with credit scores as low as 621, a significant relaxation of the 700 minimum score the company adopted just three months ago as it struggled to survive. America's median credit score is 723"¦
If you pay people trillions of dollars in response to a bad behavior (in this case, credit lenience) then you will just encourage more of that behavior, even if everyone achnowleges it to be a bad behavior.