The Politics of Risk and the Risk of Politics

Barack Obama has reached for the mantle of a transformative presidency, aspiring to recast our national social contract in the interest of greater equality and fairness. In cooperation with a Democratic-controlled Congress, he has pursued this goal by expanding Federal authority in response to economic crises and supporting interventions into finance and banking, automobile manufacturing, health care, and environmental policy. This strategy adopts the “statist” philosophy of economic risk management by centralizing governmental authority and control over private markets.

Ironically, this Europeanization of US public policy is occurring exactly when sovereign debt crises and taxpayer bailouts are casting an ominous cloud over the European model. It seems public sector risk may turn out to be more dangerous than private sector risk. But if we can connect recurring financial crises to the long-term erosion in the economic health of states, we should seriously question whether statism offers the best array of policies to manage the uncertainties of the modern world.

Let us begin with the international financial crisis. A surplus of world savings channeled by excess credit creation drove people in the developed world to overborrow and concentrate debt and risk in overpriced housing assets. Banks then distilled these risky assets in securitized debt obligations and sold them to investors worldwide. What ensued was risk mismanagement on a colossal scale, as the concentration of leveraged debt made the crash far worse than dotcom or tulip bulb mania. This shell game violated all we know about prudent risk management and sucked in politicians, central bankers, financiers, the housing industry, and citizens alike.

The response has been to substitute massive public credit for shrinking private credit, while seeking new means to regulate financial risk and reward. This sounds a bit too much like the dog that bit us. In terms of public policy it means more centralized political control over central banks and the financial sector, with unpredictable market distortions yielding more liabilities and burdens for taxpayers. The net result will be an increase in systemic risk exposure.

Let us now turn to the crisis of welfare statism. The modern social welfare state is more accurately labeled the social insurance state, as its spending priorities are dominated by programs related to old age pensions, health care, and the risks of unemployment and poverty. Social insurance has been the developed world’s primary political response to systemic risk. Regrettably, it may impose the least efficient means to manage risk, with the most costly consequences.

Financial risk is managed by saving, pooling, hedging and, most important, asset diversification. The key concepts are savings and diversification, as these underpin the logic of insurance pooling. A financially sound insurance pool must align contribution and benefit ratios according to known actuarial data and demographic trends. The Bismarckian model of social insurance faces the same criteria.

The inconvenient truth is that our social insurance programs, like Social Security and Medicare, are not really insurance pools, but pay-as-you-go transfer schemes. We tax younger workers to immediately pay out benefits to older, retired citizens. This design inflicts a host of problems and costs.

First is the agency problem. Pay-as-you-go means our Social Security and Medicare taxes have not been saved in a “trust” fund, rather they are doled out in benefit promises and used to fund other political priorities through general revenues. This is the problem of political and bureaucratic “agents” following their own short-term incentives. This is also how we get “too big to fail” and runaway budgets.

The second problem is moral hazard. Because taxes to fund entitlement transfers crowd out private savings and lead us to believe the government is saving for us, private savings decrease. This means we cannot adequately fund the economic growth necessary to fund future social insurance liabilities. The alternative has been to borrow from abroad, mostly from the Chinese.

The third problem is demographics, as birth rates decline and longevity increases. We have heard how the “trust” funds will run out or overburden younger workers as baby boomers age.

We can readily measure the consequences of our policy failures in societal risk management. Household savings rates in the U.S. have dropped from an average of 10% in the 1970s to less than 1% just before the financial crisis in 2008. The immediate response to the crisis jumped the rate to 6%, but this was offset by roughly a trillion dollars in new public debt. (Estimates for China’s household savings rate range from 25-50%)

US public debt as a percentage of GDP now fluctuates around 80%. This compares to Japan at 192%, Italy at 115%, Greece at 108%, France at 80%, and Germany at 77%. Chile, which privatized its social insurance three decades ago, services a public debt at 9% of GDP.

Our current account deficit, which measures how much more we import than export, persists at 3% of GDP while China runs a 6% surplus. In simplest terms, the Chinese are lending us money to buy their goods.

A recent survey by the Peter G. Peterson Foundation of US political leaders from both parties found unanimous agreement that US structural deficits due to entitlement programs would cause a financial collapse of US public finances within ten years unless the programs were reformed.

The reality is that a true national insurance program cannot be a shell game that transfers resources from one group to another. The nation must accumulate real savings to be invested to fund future needs. The danger of our current treatment of risk management through entitlements is that we are not really insuring against our risks, but merely passing them on to others. This is neither moral, nor economically viable.

Our only chance of solving these problems must focus on managing economic risk by boosting savings and promoting the widespread diversification of assets. The increased concentration of political, economic, and financial power currently dominating the developed world is antithetical to such solutions and financial reform should not risk reinforcing a Wall Street-Washington oligarchy. This gets us back to the regulation of finance and banking.

The unfocused blame put on markets for our financial crises is disingenuous. The heavy reliance on credit and debt, the opacity of financial technology, the capture of regulatory agencies by the industries they regulate, and volatile asset markets are all symptoms of misguided policies. History and theory have both shown how functioning private markets are most efficient in allocating and managing diversified risk. The best financial regulation, then, is not another politicized agency, but the continued promotion of open, competitive, and transparent financial markets. The caveat for financiers is that failure and bankruptcy are essential features of free markets.

A world described by risk and uncertainty is like a sea full of hidden icebergs. Politicians like to reinforce social solidarity and national cohesion by claiming we are all in the same boat and must pull together. Mr. Obama seems to favor this metaphor, but, in terms of systemic risk, it also fits the Titanic analogy. A more useful metaphor is that we are all in different boats on the same sea. This can apply to countries, states, cities, markets, workplaces, and families. The multiplicity and diversity of institutional structures is a lesson conveyed by nature through biodiversity—all we need do is apply the lesson.

As one Greek citizen was quoted on his country’s latest crisis: “It could be a chance to overhaul the whole rancid system and create a state that actually works.”

The Cast of Villains in the Financial Crisis

Good article in the NYTimes outlining the full cast of characters in the financial crisis. A full cast still on the stage...
This is what I call Casino Capitalism and Crapshoot Politics.

Tea Parties = CAP

Michael Barone's article addresses the nature of the anti-political backlash of the Tea Parties. It's is the same thing I have described as American citizens' political demands for choice, autonomy, and minimal protection from risks they can't control.

The media portrayal of the Tea Party phenomenon is misleading and can only hurt those who dismiss TPs as a fringe movement in the coming elections.

Let's Get Real.

I love this excerpt from Peggy Noonan's article in the WSJ:

This week's Financial Industry Inquiry Commission hearings were so exciting, such a public service. The testimony of Charles Prince, former CEO of Citigroup, a too-big-to-fail bank that received $45 billion in bailouts and $300 billion in taxpayer guarantees, was riveting. You've seen it on the news, but if you were watching it live on C-Span, the stark power of his brutal candor was breathtaking. This, as you know, is what he said:

"Let's be real. This is what happened the past 10 years. You, for political reasons, both Republicans and Democrats, finagled the mortgage system so that people who make, like, zero dollars a year were given mortgages for $600,000 houses. You got to run around and crow about how under your watch everyone became a homeowner. You shook down the taxpayer and hoped for the best.

"Democrats did it because they thought it would make everyone Democrats: 'Look what I give you!' Republicans did it because they thought it would make everyone Republicans: 'I'm a homeowner, I've got a stake, don't raise my property taxes, get off my lawn!' And Wall Street? We went to town, baby. We bundled the mortgages and sold them to fools, or we held them, called them assets, and made believe everyone would pay their mortgage. As if we cared. We invented financial instruments so complicated no one, even the people who sold them, understood what they were.

"You're finaglers and we're finaglers. I play for dollars, you play for votes. In our own ways we're all thieves. We would be called desperadoes if we weren't so boring, so utterly banal in our soft-jawed, full-jowled selfishness. If there were any justice, we'd be forced to duel, with the peasants of America holding our cloaks. Only we'd both make sure we missed, wouldn't we?"
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OK, Charles Prince didn't say that. Just wanted to get your blood going. Mr. Prince would never say something so dramatic and intemperate. I made it up. It wasn't on the news because it didn't happen.

It would be kind of a breath of fresh air though, wouldn't it?

Alan Greenspan on the Financial Collapse

Have to agree. Greenie gets it only half right. Bubbles thrive on leveraged credit. The Fed can easily dampen excess leverage and also send the right signals to the shadow banking system to reduce moral hazard. We didn't get the "Greenspan Put" from the Easter Bunny.

Alan Greenspan on the Financial Collapse

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Debt Crisis = A Failed Policy Paradigm

The financial crisis of 2008 paved the way for the employment crisis of 2009, which has now paved the way for the upcoming public finance crisis of 2010. Most federal, state and municipal budgets are strained to the breaking point while the economy still has not found its footing. Meanwhile our national politics is obsessed with expensive overhauls of environmental policy and healthcare reform. Our latest policy strategy is an attempt to borrow and spend our way to prosperity, ala Japan of the past twenty years.

It’s tempting to point to a few simple causes of these economic misfortunes, such as mortgage subsidies, loose credit standards, or excess financial leverage, but the truth is that we are experiencing the fallout of a failed policy paradigm.

This paradigm was rooted in the past century with the creation of the Federal Reserve in 1913, the Employment Act of 1946 and the Humphrey-Hawkins Full Employment and Stabilization Act of 1978. It’s a paradigm dependent on many admittedly useful policy tools, including both Keynesian demand stimulus and the Austrian school’s theory of money and credit, the monetarism of Friedman, as well as the supply-siders of the 1980s.

So, in what ways have these approaches failed?

The policy goals are clearly stated: stable GDP growth and full employment. But the economic results have been decidedly mixed: the growth of real incomes laden with an exploding entitlement state, structural budget crises, widening wealth disparities, a catastrophe-prone banking system, and volatile asset markets. We’ve heard the term “systemic risk” bandied about the recent financial crisis, but this report card captures the true risks of the system we’ve created.

Politically and socially, Americans clearly want a society where a growing middle class thrives, opportunity exists for individual success and advancement, and a prosperous elite accepts the responsibilities of power not to exploit the weak and disadvantaged. Instead, our political economy is hollowing out the middle class, creating more dependency among the poor, and fostering a culture of corruption and irresponsibility among the elites . Elsewhere I’ve characterized this current state of affairs as Casino Capitalism and Crapshoot Politics.

Second question: why has our democratic politics failed to deliver? The short answer: Our government is doing too much of what it shouldn’t be doing and not enough of what it should.

Free market economies are very good at producing wealth by harnessing the incentives of market participants. Market prices are valuable information signals that tell everyone how much of each good to produce. Governments, however, no matter how enlightened, cannot attain this efficiency. But, due to the political imperative to “do something” in response to countless demands, they feel compelled to try. Thus the focus on “growing the economy” and “creating jobs.”

Unfortunately, these goals often demand incompatible policies, highlighting the differences between the private and public sectors. Private firms earn profits (i.e., create wealth) by increasing productivity, often by reducing labor costs. However, the public sector follows no profit criteria, so the government increases employment without attention to productivity. Thus, with more public sector jobs we create more employment while producing less. At the same time, the growth of the public sector empowers a politically powerful public union interest in its continued expansion. This is no way for a nation to grow rich.

When we peal away the logic we find the true goal of public sector job creation: political redistribution of the economy’s wealth-creating capacity in order to mitigate the effects of markets. This is not an unworthy societal goal, but our public policies adopt counterproductive means to achieve it.

To be fair, the political problem arises because private markets are agnostic towards the distributional effects of their success. Inequality, poverty, pollution, environmental degradation, the concentration of economic and political power—all these are unfavorable distributional effects of markets that give rise to political demands. The question is over how government should meet these demands.

The 20th century attempt to tax and redistribute wealth has landed the modern welfare state in a cul-de-sac of exploding budgets, rising costs of living, slower economic growth and structural unemployment. We’re robbing Peter to pay Paul and neither – except for a relative handful of bureaucrats and rent-seeking capitalists - is better off for it. This adds up to less opportunity all around. Again, the problem is with our failed paradigm. We need to align our policies with behavioral incentives without surrendering our policy goals to an agnostic market mechanism.

To construct a new paradigm we might do best to return to first principles of what Americans want: freedom, opportunity and justice. In order to enjoy these principles, citizens need to be empowered with choice, autonomy, and protection from unmanageable risks. Only functioning free and competitive markets can provide the necessary resources.

So, what should be the proper role for government?

The maldistribution of resources can be mitigated if citizens participate in the wealth creating process as more than an input labor cost. Public policy should cease deficit spending to promote employment and instead look to creating the necessary environment for private risk-taking, saving, investment, and production. This includes insuring market competition and mitigating the effects of economic risk and uncertainty. Tax and regulatory policies should promote the widespread accumulation, diversification, and access to capital to empower individuals and families with the necessary resources to build wealth and insure themselves against uncertainty. Where private insurance markets are incomplete, there is a role for limited social insurance to fill the gap.

Numerous specific policies flow from this general paradigm shift, for example, we can stop penalizing savings through overly loose credit and onerous tax policies on interest and dividend income. There is no reason not to have a tax-free threshold for capital income that reflects the desired savings level of the median annual income household.

Why have we stuck with a failed policy paradigm? Part of the answer is the Kuhnian nature of scientific revolutions, but the pursuit of power and influence by narrow interests is certainly a determinant factor. Economically and socially, we know where we need to go. Getting there politically is another matter. Our present political leadership (of both parties) certainly is not taking us in that direction.

Debt Clock

A YouTube video on our exploding national debt...