Socialization of Risk
by tdaxp ~ September 18th, 2008
The government interferes in the economy in two basic ways: to plan it and to socialize risk. In general, the political economy of the 20th century was the decline of economic planning and the rise of the socialization of risk. Planned economies such as the Soviet Union, post-War Britain, and post-War China collapsed in on themselves, ending with Winters of Discontents, failed coups, or economic revolution.
The socialization of risk, however, has been the basis of much of our economic growth. Public pensions such as social security allowed families to leave their farms and businesses, knowing that they would not starve in old age. The Federal Deposit Insurance Corporation families reinvest in the economy, rather than storing their cash under their mattresses. We seem to be on the verge of a Federal Bond Insurance Corporation, which will socialize much of the risk of bond markets away from large private institutions such as AIG. The solution may even be international.
If there is a silver lining to the financial cloud over Wall Street, it is hopefully a greater acceptance of the socialization of risk in our economy. While we should minimize moral hazard where possible, we must also realize that programs such as social security and FDIC are part of the solution, not merely a burdensome federal responsibility. The next step will probably be national health care.
Reading recommendation: A Future Perfect, by John Micklethwait and Adrian Woolridge.
Tim, Based on the traditional laws of the United...
September 18th, 2008 at 11:27 pm
Today I was watching Obama respond to McCain’s claim that “the fundamentals of the economy are strong.” Obama went on to say ”
“We’re in the middle of the second-biggest Dow Jones drop this century”
Well, that wasn’t exactly correct. On Wednesday the Dow fell 4.4%. But after 9-11 it fell 7%, after the IT bubble broke it fell 6% and in the summer of 2002 it fell 6%.
McCain then came out later and changed his mind and agreed with Obama. I think McCain made an error here. The fact is, the fundamentals of the US economy ARE strong. I view the “fundamentals” of the economy as being the right to private property, low taxes, and a dynamic business environment. McCain should have brought this up, and warned the country that an Obama presidency would place the fundamentals in jeopardy.
Also, the economy is very sensitive to people’s perceptions. While it is experiencing some troubles now, its important for leaders to still remain positive in public. Just like when Obama is out in Chicago telling people how they bad they got it, he appears to be doing the same thing in regards to the economy? People need to take a deep breath and not panic right now. The worst thing people can do right now is start pulling their money out.
The most frustrating thing is that people like Obama are part of the reason the economy is reacting like it is in the first place.[1] It was people like him, and other community agitators, who forced banks to start lending to people who had no business owning their own pup-tents, much less their own $300,000 dollar homes.
Of course McCain will never say this. And it doesn’t seem that the big shots on Wall Street are willing to say anything about this either. I try to stay away from conspiracies, but sometimes it appears like the elites want some sort of depression so they can implement large scale “change?”
Nevertheless, I’m not sure your (Dan) theory is correct regrading incompetents in government? You say that its better for the smartest people to be in industry instead of government, but aren’t we seeing that this might not be true? Then again, maybe its more important that government personnel just be able to make tough decisions? And I’m not talking about the “tough decisions” that Patriotard conservatives like Hannity claim President Bush has made. I’m talking about saying NO to community agitators when they push for irrational policies.
I appears to me that its easier to bring this country to war than it is to stand up to the forces of political correctness? The poison of PC is seeping into every fabric of American life. From not allowing kids to play dodge-ball, to giving out houses like food stamps, if someone doesn’t put an end to this its going to put an end to us. When I see a leader who will stand up to the forces of PC, then I’ll vote for someone. Until then, I’m not voting for anyone.
[1] http://www.ibdeditorials.com/IBDArticles.aspx?id=306370789279709
September 19th, 2008 at 4:04 am
On CNBC, Larry Kudlow noted that politically the Congress should stall on bad-bond reform, because passing such legislation can only help the economy before election day. We will see.
Obama’s word is worthless [1,2], so hopefully people are just annoying him. If he does win, a post-presidency beginning on Day 1 would not be so bad.
[1] http://www.tdaxp.com/archive/2008/09/18/obamas-policy-toward-china.html#comment-137527
[2] http://www.tdaxp.com/archive/2008/07/03/barack-obama-please-flip-flop-on-colombia.html#comment-96243
September 19th, 2008 at 4:54 am
When I read things from Fabius Maximus and Ludwig Von Mises Institute they abhor such actions by our government. Any response to these critics?
September 19th, 2008 at 6:06 am
You make up more ground here Dan. SO I will comment here.
I don’t take you to mean that all risk should be socialized. But more importantly, I don’t understand what your position is on the gains.
Clearly all risk shouldn’t be socialized. Yet, the vast majority of gains are privatized. If you look to history, you see that such an economy doesn’t last long. Nor should it.
Let me spell the problem out another way. Are the smaller insurers right now thinking to themselves “damn, I wish I had taken on more risk!”? And are investors saying to themselves, “damn, I sure hope all my money is in too big to fail (TBF) bonds”?
At the end of the day, if you want to socialize more risk, wouldn’t you need to socialize more of the gain as well?
September 19th, 2008 at 6:25 am
Seerov says,
“People need to take a deep breath and not panic right now. The worst thing people can do right now is start pulling their money out.”
I would take issue with that. From a social perspective (common good for the common market) you are quite right. From an individual perspective, I think you are wrong.
FDIC is going to run out of money soon. Until then, the only sure thing is to leave your money in accounts of no more than 100K with major retail banks. That is the only “safe” play left.
To leave your money in the market is to accept the risk that the market will correct itself over time. If you are in your 30s, that is not such a bad idea. If you are a corporation that will live forever, it might even be a good time to look for value in equities. But if you are a retiree trying to preserve your capital for your remaining years, you probably don’t want to accept the risk of the markets right now. Nor should you.
September 19th, 2008 at 6:33 am
Glenn,
Like zenpundit I admire that Fabius is attempting to analyze the crisis.
That said, his remarks appear to be self-contradictory [1] and generations out of date [2].
As for von Mises, my skepticism of “Austrian Economics” has increased since I realized that it is a branch of philosophy rather than, say, economics. [3]
Fed X,
Your point is important. Clearly the positive externalities of a transaction is important to consider. In the case of social security, the direct gainers are those who receive more from the system than would have otherwise had, though the increased labor mobility and risk-taking may help the entire economy.
Certainly we should expect a more comprehensive regulation agency, which will socialize a great deal of market information that till now has been privately held. (For instance, the portfolios of short-sellers.)
[1] http://fabiusmaximus.wordpress.com/2008/09/18/roubini-3/#comment-7313
[2] http://fabiusmaximus.wordpress.com/2008/09/19/constitution-2/#comment-7359
[3] http://www.tdaxp.com/archive/2008/01/21/is-austrian-economics-pseudo-science.html#comment-137530
September 19th, 2008 at 8:10 am
But what about all the profits? Would you recommend a back tax or some punitive sanction on the firms and individuals that profited all this time so that these gains could be socialized as well?
I don’t think you would, but I don’t know. This is a very serious question however as your post leads one to believe that you favor a socialist experiment in all institutions of systemic importance.
September 19th, 2008 at 8:25 am
Fed X,
Thank you for your fascinating question.
To clarify, what would be the purpose of this, and who would be the intended punishee (the corporate person of the corporation, the shareholders, the bondholders, executives, etc?).
September 19th, 2008 at 8:33 am
I’m not sure who the intended punishee would be. But it would seem to me that if we are going to, ex post, socialize the risk, then we would also want to, ex post, socialize the gain. The gains were in the form of profits for anyone in the securitization chain that made substantially more than median profit increase over the last eight to ten years.
GS, Morgan, to be sure, but also the large retail banks, mortgage originators, and of course the hedge funds (little close to home there).
Their profits zoomed wildly out of proportion as a result of the junk trade of illiquid assets.
Now you recommend the socialization of this mess going forward, as does Paulson, Bernanke, virtually every economist, the Congress, and both Presidential candidates. You are obviously in good company.
But if society is to bear this burden, which it seems inevitable they will, shouldn’t society be allowed to reap some of the ill-gotten past gains as collateral?
Again, the simple scenario here is you have proposed socializing the risk of systemic financial failure, but have not yet dealt with the fact that we are still privatizing financial gains. Are you asking the American people to take the risk, but not the upside? Or are you just leaving the upside out of the equation for simplicity’s sake?
September 19th, 2008 at 10:48 am
Fed X,
Thank you for your response.
I am still unclear on some things
You say “I’m not sure who the intended punishee would be. ” but also “The gains were in the form of profits for anyone in the securitization chain that made substantially more than median profit increase over the last eight to ten years.” I’m not sure how to reconcile these statements. Are you advocating punitive taxes against any organization in the securitization chain that enjoyed more than a median increase in profits?
Likewise, I’m not sure if you are suggesting punitive taxes as a method for increasing economic growth, or for righting past wrongs.
September 19th, 2008 at 11:45 am
It appears we’re both trying to understand the other. When I say, I’m not sure “who” is being targeted, what I mean is I’m not sure which institutions exactly you would like to see have their private gains socialized in order to balance the risk socialization you argued for. My proffer of the firms in the securitization industry was just that, in other words, do you mean those firms, or some others?
As for righting wrongs, etc. It was you who proposed socializing risks as an ameliorative action. Well, to be fair, it is virtually everyone right now advocating such a course. I have no quarrel with this argument (well, I do, but it isn’t my purpose here to debate that).
But I understood you to agree with me that socializing risks without a balanced socialization of gains was normatively prohibited.
Perhaps I was mistaken in that understanding. So let me repose the question:
You state:
“If there is a silver lining to the financial cloud over Wall Street, it is hopefully a greater acceptance of the socialization of risk in our economy.”
My questions are thus:
(1) Do you agree that this “silver lining” is ex post (i.e., after the fact that the was risk was taken, which at the time was a private risk)?
(2) Do you agree that many gains were made for taking this risk initially?
(3) Do you agree that such gains were privatized?
(4) Do you agree that, in fact, what is being socialized is the rather large losses that many of the risk takers now find themselves with?
(5) Do you agree that normative considerations counsel for socializing gains alongside losses to make such losses (or risks if you prefer) more equitable?
Please let me know if that all makes sense. Reply privately if you don’t understand the questions, I don’t want to take up undue space on your blog in a discussion of particulars. If this all makes sense, please respond to the questions and give me your additional comments or criticisms, such as they may be.
Finally, let me throw out one more issue with a downside risk of perceived risk socialization. Where there is risk, there is reward. If the State takes on the risk, it takes on the prospective reward as well. One danger in allowing the State to do this is that financial innovation (the process by which financial risk turns to profit) moves off shore or onto another Continent entirely. Leaving the State stuck in a rut of diminishing returns. Have you considered that possibility? How remote, or not, do you see such a possibility? Note: this isn’t meant to distract you from the above, simply to toss out some more food for thought.
September 19th, 2008 at 12:12 pm
Fed X,
Thanks for your thoughtful post.
My responses to your question:
Greater acceptance of socialization of risk follows after this week’s crisis, so “yes..”
Yes.
Yes, though of course there were positive externalities
Yes, though of course the magnitude is presently unknown.
I’m not sure what is meant here. A Federal Bond Insuracnce Corporation or Federal Money Market Insuracne Corporation has positive externalities, and so I imagine something like them will be created. That said, your phrasing sounds like an argument for social justice, which is a zero-sum approach to the economy that is both short-sided and counterproductive.
Given the choice between punishing someone for following the laws in a way I now dislike — or focusing on economic growth and the general welfare — I care little about the former, and a lot about the latter.
Agreed. Even a ‘money-losing’ program like Social Security greatly expanded the capital cash on hand of the fedearl government for decades, allowing a lot to be done that otherwise could not have.
This has definitely happened after SarbOx. There are bad regulations.
Corporations are naturalyl risk-averse. SarbOx creates a lot of new risks, and so chases companies away. However, the whole Credit Default Swap (bond insurance) industry existed to minimize risk. Some sort of FBIC/FMMIC would lower this risk, and so attract business.
September 19th, 2008 at 12:27 pm
Speaking as a member of the CDS industry, I can tell you that the raison d’etre was overtly as you stated, but certainly not at all the purpose of the trades that were made. That isn’t really relevant to the discussion, except insofar as it points out the difference between a market’s motives and the motives of market participants operating within it. It would be a bit like saying the black jack table exists so that the customers can have tables with better odds than roulette. In fact, they exist independently (and indeed, in spite of) risk.
So, it seems I did misunderstand you. Your proposal is then best reflected by this statement:
Socialization of risk is positive for economic development, but socialization of gain is not.
Any gains that are socialized are limited to those gains derived from the risk that was socialized, going forward from the date of socialization.
Is that correct?
September 19th, 2008 at 12:34 pm
Socialization is not a scheme to increase government revenues directly (such socialism has since died a sorry death), but rather as a method to allow individuals to invest capital in wealth-generating activities that would otherwise be spent on disaster-avoidance activities.
Take health care, for instance. Socialization of health insurance would not be to divert profits currently enjoyed by health care companies to the federal treasury. Rather, it would allow people to leave their jobs more easily, grow new companies more easily, and move around more easily.
The role of speculators within a system that is primarily intended to better invest capital and reduce risk is a complicated one. At best, speculators probe for weaknesses that would otherwise stay hidden and speed up the freeing of capital. At worst, they form an secretive herd. Thus the need for regulation of them.
September 19th, 2008 at 12:41 pm
That’s fine, but you didn’t answer the question. In this instance, where the plan is being put forth that we retroactively socialize risks incurred by the TBF entities, you do not see any need to retroactively socialize the gains won by the TBF entities Is that right?
I know you want to talk social security and health care, and I’m happy to do that, but I’d like to nail this down first as it impacts my thinking going forward.
September 19th, 2008 at 12:43 pm
Sorry for the ambiguity.
Of course not.
Morally, we should not punish legal activities.
Constitutionally, we cannot past ex-post facto laws.
Practically, we have better things to do.
Now, obviously there are bankruptcy courts, the costs of regulations, etc., but it sounds like you were thinking of something beyond that.
September 19th, 2008 at 1:01 pm
In fact, I was thinking of bankruptcy. You see it matters greatly that Fed decided to intervene prior to bankruptcy in the case of AIG (and Bear Stearns). Clearly, they acted at that time because the indentures of practically every piece of paper printed say that entering 11 or 7 or any sort of bankruptcy proceeding is a default. In Wall St parlance, a “credit event.”
Now what would have happened if the Fed decided to intervene on day one of the bankruptcy filing? They could have done that, and provided the DIP loan to effectively take over the company at that point. Sitting as chief super-creditor and operator of the dead remains of AIG rather than chief super-equity holder of a dying, barely breathing AIG.
More importantly, the risks to taxpayers would have been greatly reduced. All unsecured creditors would be trading junk right now (which is what they were and are trading anyway, its just not rated junk), all equityholders would be wiped out, and the Fed would be in a position to reap substantial profits after AIG’s bankruptcy was concluded and its balance sheet cleansed of the poisonous toxicity previously pulsing through its veins.
Would there be negative externalities to the aforementioned credit event? Why yes. Many banks, especially Wachovia, would have been pummeled for lending so much money out on so little collateral. The bonds would be worthless, or near worthless, and the bondholders would see their assets shrink overnight.
I do not think, however, that the fallout would have lasted long. Indeed, a DIP loan from the Federal govt. would be sufficient to keep the company operating as long as necessary in order to wind down its affairs in an orderly fashion. And moreover, we could finally have a debtor (the US Govt) in a position of strength over and beyond creditors and work out once and for all the true foundations of securitization, which are rotten to the core and would result in reverse capital flows from MBS owners to debtors in general. But I am seriously digressing.
So then you agree that risks, when systemic at least, should be socialized, yet the gains leading to them should be privatized. This is, in sum and substance, a corporatist economic model. Let’s be clear about that. Is that correct? You are advocating switching the US over from a capitalist based system whenever aggregate systemic risks are triggered to a corporatist based system where gains are given to the few, while losses shared by the many, are you not? And one follow up on this before I post, how do you decide which risks are going to be socialized? Is there some apriori definition of systemic you have in mind?
September 20th, 2008 at 7:22 am
Federalist,
Indeed.
As a major poitn of the bailout was to protect the creditors, however, doing so would defeat the point.
I’m not a socialist (that is, I don’t want to see the nationalization of industry in an attempt to increase the profitability of the government), so I would oppose such a move.
As I understand the term, corporatism is a political system where special interests are reprsented in a legislative or consultative body. So that Italy historically, and Hong Kong now, are corporatist states.
I don’t understand how national health insurance, federal bond insurance, federal deposit insurance, amounts to corporatism.
September 20th, 2008 at 9:52 am
I wasn’t saying national health insurance or any of the others amount to corporatism. They do, though, amount to socialism. A little socialism here and there never killed anyone.
What amounts to corporatism however is selectively nationalizing financial institutions to keep them from bearing their own losses, socializing those losses, but leaving all gains privatized. In other words, the “connected few” get the profits, while the masses are stuck with the losses. Not exactly an equitable arrangement you would agree.
If you’re ok with this, I salute you. I’m not. I can’t bear to see this happen to a country that was once the envy of the world in terms of markets. It is now a laughing stock.
September 22nd, 2008 at 9:23 am
It’s interesting to note that Russia, since late 2005, has begun to refer to itself as a corporatist state, ruled by the security services. To paraphrase one Russian observer, there is no corruption in Russia. Corruption involves powerful outsiders granting bribes for official favors. In Russia, the businessmen and the politicians and the bureaucrats are the same people.
Usually, corporatism involves a state partnership with the leaders of various economic sectors (a cartel, a union of unions, a profesional guild) to encourage “fair” economic development. Unfortunately, since some people are not represented by leaders as a sector (most notably, the unemployed), or underrepresented, those people tend to suffer disproportionally.
September 23rd, 2008 at 8:26 am
Federallist,
Ah. I wasn’t aware that you were using the word ‘corporatism’ in such a quixotic and odd way.
I find it is easier to talk to others if I stay to words actually mean.
Dan McIntosh,
Indeed. The apparent success of Hong Kong under such a system hopefully can be a path to development for other authoritarian states. Still, Putin’s foolish belligerence and destruction of domestic political institutions would seem to make that unlikely for Russia.