Question

10. What are the moral hazard and adverse selection when the borrower is a national government?

• Give one example of the adverse selection and the moral hazard behavior.

• Use an example of a country whose government defaulted (=refused to pay) on its national debt

Answer 1

The concepts of moral harad and adverse selection are explained as follows:

Moral Hazard: An example can be for instance country A borrows a sum of $10 billion from China. Once the money has been borrowed on goodwill (China will not have many options if the country defaults apart from refusal to end again) country A decides that it will take excessive risk. It invests money in highly risky investments that fail and the country A actually defaults. This is a moral hazard as once the country A got the loan, its behaviors changed in a manner that damaged the other party, China.

Adverse selection: Suppose there are two countries, A and B that want to borrow funds from the China. A is a highly risky borrower and B is a safe borrower. China does not know who is safe. Based on some probabilities, it charges an average interest rate of 10%. If A was willing to accept the loan for 12% and B for a maximum of 8%, B is driven out of the market as the interest is too high. Thus, there is only the risky borrower that remains in the form of A. The abd player had driven out a bad player from the market. This is adverse selection.