Question

As the Great Recession was unfolding, why did the U.S. government officials struggle with the trade-off between preventing ‘moral hazard’ and preventing ‘systemic risk’?

Answer 1

The recession occurs when the demand is deficient in the economy and it reduces economic activities incredibly. The government often comes forward to deal with recessionary conditions.

Moral hazard refers to the phenomena where the risk-taking behavior rises when someone is ensured with insurance. Further, systemic risk is associated with the entire financial system. Through the cascading effect or spillover effects, the entire system would crumble down.

With the frequent bailout and insurance for crisis-ridden countries or firms, the risky behavior rises and lenders do not exercise due diligence to avoid the potential defaults. Thus. it risks the stability of the entire system.

Thus, here the tradeoff between these two objectives arises, the moral hazard problem can lead to failure of entire system. thus, here the government must go for the avoiding the sytemic risk.