Moral hazard is a costly behavior because the insured party acts riskier than they would normally, knowing that they’re covered, and insurance companies allow it because they can sell more policies in addition to receiving bailouts from the government.
It is natural for moral hazard to happen, but its effects can have consequences. This was seen during the 2007–2008 financial crisis on Wall Street that later led to the Great Recession.
Because interest rates were at an all-time low, credit was incredibly cheap, and borrowing money was easier than ever. Borrowers rushed to buy homes, including those who could not previously afford it. Money lenders approved loans and sold them to banks, which were marketed and sold as low-risk investments. The loans were then sold to investors who were looking to make an easy profit.
The U.S. Federal Reserve then increased interest rates as the economy was recovering, but as a result, the housing market crashed because people were unable to make their mortgage payments. Property values then dropped and many homeowners left their homes because they were worth less than their debt. In the end, trillions of dollars in capital were lost from the global banking system as many lenders filed for bankruptcy.
Eventually, numerous huge banks and insurance companies were bailed out when President George W. Bush passed the Troubled Asset Relief Program ("TARP"), costing taxpayers $700 billion.
What is the concensus of how economists believe the government should deal with occurences of moral hazard of this magnitude?
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