"In politics we learn the most from those who disagree with us..."

"The great enemy of the truth is very often not the lie--deliberate, contrived, and dishonest; but the myth--persistent, persuasive, and unrealistic. Belief in myths allows the comfort of opinion without the discomfort of thought." - John F. Kennedy




Purple Nation? What's that? Good question.

Neither Red nor Blue. In other words, not knee-jerk liberal Democrat or jerk Republican. But certainly not some foggy third way either.

In recent years partisan politics in America has become superimposed on cultural identity and life style choices. You know - whether you go to church or not, or whether you drive a Volvo or a pickup, or where you live. This promotes a false political consciousness that we hope to remedy here.

There are both myths and truths to this Red-Blue dichotomy and we'd like to distinguish between the two. So, please, read on, join the discussion, contribute your point of view.

Diversity of opinion is encouraged...

Wednesday, June 23, 2010

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.”

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