The eco­nomic the­ory of moral haz­ard is “the prospect that a party insu­lated from risk may behave dif­fer­ently from the way it would behave if it were fully exposed to the risk” (e.g. hold­ers of car insur­ance may engage in riskier behav­iour than non-holders, investors may take unnec­es­sary risks if they expect to be bailed out in case of huge losses, etc.).

James Surowiecki—author of The Wis­dom of Crowds—ques­tions the valid­ity of the the­ory, claim­ing that we may be over­es­ti­mat­ing the effect of moral haz­ard… if it exists at all.

The biggest rea­son that moral haz­ard mat­ters less than it might is that it can oper­ate only if peo­ple actively coun­te­nance the pos­si­bil­ity that their deci­sions could lead to com­plete dis­as­ter. But it’s well doc­u­mented that peo­ple gen­er­ally, and investors par­tic­u­larly, are over­con­fi­dent and sig­nif­i­cantly under­es­ti­mate the chances of being wiped out. The moral-hazard fun­da­men­tal­ists argue that banks and other finan­cial insti­tu­tions will act reck­lessly if they think they’ll be res­cued in the event of fail­ure. But Wall Street was reck­less because it never believed that fail­ure was even a possibility.