Established economic theory - pioneered by Merton in 1977 - shows that,
counterintuitively, the closer a bank is to insolvency, the more
inclined it is to risky lending. Nobuhiko Hibara of Columbia University
demonstrated this effect convincingly in the Japanese banking system in
his November 2001 draft paper titled "What Happens in Banking Crises -
Credit Crunch vs. Moral Hazard".
Last but by no means least, as opposed to oft-reiterated wisdom - the
markets have no memory. Russia has egregiously defaulted on its
sovereign debt a few times in the last 100 years. Only four years ago
it thumbed its nose with relish at tearful foreign funds, banks, and
investors.
Yet, it is now besieged by investment banks and a horde of lenders
begging it to borrow at concessionary rates. The same goes for Mexico,
Argentina, China, Nigeria, Thailand, other countries, and the
accident-prone banking system in almost every corner of the globe.
In many places, international aid constitutes the bulk of foreign
currency inflows. It is severely tainted by moral hazard. In a paper
titled "Aid, Conditionality and Moral Hazard", written by Paul Mosley
and John Hudson, and presented at the Royal Economic Society's 1998
Annual Conference, the authors wrote:
"Empirical evidence on the effectiveness of both overseas aid and the
'conditionality' employed by donors to increase its leverage suggests
disappointing results over the past thirty years .
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