Risk in a Free Society

Risk in life cannot be eliminated, but it can be managed. This is the nature of a dynamic universe undergoing constant unpredictable change. This article from City Journal explains well the role risk and uncertainty plays in our lives. [Comments in red italics.]

Propeller of Growth

Technology and globalization are changing the nature of work and commerce, displacing workers, and altering the way of life for many people. In response to this uncertain economic environment, policymakers from both parties have become preoccupied with reducing risk. But many of their risk-management proposals go too far, address the wrong sources of risk, and would undermine America’s economic leadership.

The general conception of risk management is that it serves to eliminate bad outcomes. On the plus side, risk propels economies and motivates entrepreneurs to innovate. Risk, for better and worse, is at the heart of economic growth, and successfully apportioning it—not avoiding it—is the key to prosperity. The purpose of markets is not only to match buyers and sellers and establish prices but also to allocate risk. In a functioning market, people who take the most risk can reap the biggest reward. Those who wish to avoid risk can reduce it by hedging or diversifying or by paying someone, in the form of insurance, to take on the downside risk for them.

Sometimes reducing risk is impossible because a market has distortions or is incomplete, leaving participants bearing more risk than they would like. For example, a worker may want to reduce the risk of losing his job by saving money or by pooling his risk with other workers. These options are difficult, though: he may not have enough money to save, and a market for private wage insurance doesn’t exist because it’s not profitable for insurance companies.

Government can fill this void, providing some protection, so that bad luck doesn’t leave people destitute. Unemployment insurance, for instance, pools risk for workers, a certain percentage of whom are out of work at any given time, while Social Security diversifies risk across generations. The government can foster functioning financial markets, enforce property rights, and maintain rule of law to create an environment where taking risks is rewarded. But too much intervention distorts choice by encouraging people to take the wrong risks or by eliminating risk-taking altogether.

Progressives, calling for greater government intervention, often cite the work of Yale political scientist Jacob Hacker, who argues that income has become unstable and retirement riskier. [Note: Hacker’s research is illuminating, but the reasons he cites for increased risk burdens are more related to financial policy that has increased the volatility in asset markets while increasing inequality between the asset-rich and asset-poor.] But economists, using Social Security earning records, found that income volatility (as represented by year-to-year income shocks) has actually decreased since the late 1970s, and that job stability has increased since the 1980s, with average job tenure longer now than it was then. [Note: And neither of these measures is measuring the inequality of asset markets.] It’s true that breadwinning has gotten riskier, especially for low-income workers, who face longer spells of unemployment during recessions and higher vulnerability to being replaced by technology. But progressive policymakers are addressing the wrong problems, focusing on solutions better suited to dealing with year-to-year wage volatility than with systemic risks associated with long-term economic change.

California recently enacted AB5, a law regulating freelance “gig work,” the growing popularity of which is often regarded as a signal of the American worker’s tenuous economic situation. But contrary to popular perception, gig work is usually supplementing traditional work, not replacing it. The number of workers who claim contract work as their primary job has fallen; what has gone up is the number of Americans who do gig work to smooth out income drops or periods of unemployment. The flexibility of freelance labor is what makes gig work a valuable risk-reduction strategy—it needn’t interfere with a primary job, job training, or a job search. California’s effort to standardize gig work, with regular hours and benefits, is thus counterproductive, and will result in fewer options for workers. [Yes.]

Counterproductive, too, are bigger policies targeted to the middle- and upper middle-income brackets. Both Bernie Sanders and Elizabeth Warren would like to eliminate risks associated with middle-class wealth by making college free, cancelling student debt, and expanding Social Security. But college-educated workers, even indebted ones, have lower rates of unemployment and experience joblessness for shorter periods. They are also better equipped to acquire new job skills years after they finish college. Given limited government resources, ameliorating risk for the college-educated should be a lower priority than helping less-educated workers in rural areas, who face higher risks of economic hardship.

Expanding Social Security doesn’t reduce the biggest risk in retirement, either. Americans have more income in retirement than ever before. Defined-contribution retirement plans like 401(k)s shift risk onto individuals, but they also cover many more people than defined-benefit pension plans ever did. The major risk that Americans face is the prospect of high long-term-care costs not covered by Medicare. Affordable long-term-care insurance is practically nonexistent because it’s unprofitable for insurance companies to provide. This creates a potentially huge financial and time burden for many families—one much worthier of government resources than expanding Social Security benefits. [The solutions to long-term care are health savings accounts promoting a higher level of national savings for end-of-life costs. Certainties in life must be paid for through savings, not insurance. Our entitlement programs discourage that saving.]

American health care is expensive and uncertain and suffers from coverage gaps. But nationalization of the multitrillion-dollar health-care industry will stifle innovation, as will Warren’s plans to pay for expanded health care, Social Security, and education programs by limiting returns on investment. She plans to increase capital gains and corporate taxes, set a 14.8 percent tax on income exceeding $250,000 (including investment income), and impose a constitutionally dubious wealth tax on fortunes greater than $50 million. The rewards from risk-taking are what motivate entrepreneurs to innovate despite high odds of failure. Punitive taxation on income and capital gains is a means of managing risk by capping the reward of taking it in the first place. But a growth-oriented economy demands that all participants in a risk-taking venture be rewarded, including investors and early hires. [Note: Most definitely. Assuming and managing risk-taking is the key to successful participation in a capitalist society. This is also the solution to the inequality problem over time.]

Some Republicans are also responding to the new economy by embracing more government intervention to reduce risk. President Donald Trump makes no secret of his desire for the Fed to lower interest rates in order to boost the stock market. But the Fed’s efforts to minimize risk by keeping rates artificially low in a growing economy create distortions and bubbles by making loans artificially cheap and encouraging leverage. This strategy may reduce short-term asset volatility but at the cost of more severe systemic risk.

Senator Marco Rubio, a former and perhaps future presidential contender, hopes to reduce the risk of American failure in global markets by advocating industrial policy that subsidizes particular industries. This puts the government in the role of picking winners—something it has shown little faculty for doing—and distorts risk-taking. As economic historian Joel Mokyr has argued, innovation is never predictable, especially in a transitioning economy. New technology often creates a market that no one could have predicted. Subsidizing pet industries slows and distorts the discovery process, funneling capital to the wrong places and putting entrepreneurs who want to take a chance at a fledging, not yet favored, industry at a disadvantage when it comes to raising capital. It’s true that industrial policies worked in some Asian economies, but these policies made use of already market-proven technology. Industrial policy is less effective for economies that hope to maintain a leadership role.

The U.S. economy gained supremacy by trusting markets to allocate risk, by letting people fail, and by rewarding those who thrived. Government has a role to play in reducing risk, but to do its job well it needs to be clear about what the most pressing risks are and how best to address them—while still rewarding risk-taking. 

 

Regulatory Capture 101

GSIt has always astounded me that so many people still believe that human behavior can be perfected through the oversight of a government bureaucrat. As if Goldman Sachs didn’t get a sweetheart deal from regulator Tim Geithner. (Where’s Tim now? Oh, running the private equity firm of Warburg Pincus.)

The most efficient and just regulator in existence is an open, competitive market that cannot be captured by narrow interests. This is James Madison’s prescription for democratic government and Adam Smith’s for free markets. From the WSJ:

Regulatory Capture 101

Impressionable journalists finally meet George Stigler.

Oct. 5, 2014 5:28 p.m. ET The financial scandal du jour involves leaked audio recordings that purport to show that regulators at the Federal Reserve Bank of New York were soft on Goldman Sachs . Say it ain’t so.

The news is being treated as shocking by journalists who claim to be hard-headed students of financial markets. One especially impressionable columnist calls it “a jaw-dropping story about Wall Street regulation.” The real scandal here is the excessive faith that liberal journalists and politicians continue to put in financial regulation. The media pack is discovering regulatory capture—a mere 43 years after George Stigler published his landmark paper on the concept.

The secret recordings were made by Carmen Segarra, who went to work as an examiner at the New York Fed in 2011 but was fired less than seven months later in 2012. She has filed a wrongful termination lawsuit against the regulator and says Fed officials sought to bury her claim that Goldman had no firm-wide policy on conflicts-of-interest. Goldman says it has had such policies for years, though on the same day Ms. Segarra’s revelations were broadcast, the firm added new restrictions on employees trading for their own accounts.

The New York Fed won against Ms. Segarra in district court, though the case is on appeal. The regulator also notes that Ms. Segarra “demanded $7 million to settle her complaint.” And last week New York Fed President William Dudley said, “We are going to keep striving to improve, but I don’t think anyone should question our motives or what we are trying to accomplish.”

On the recordings, regulators can be heard doing what regulators do—revealing the limits of their knowledge and demonstrating their reluctance to challenge the firms they regulate. At one point Fed officials suspect a Goldman deal with Banco Santander may have been “legal but shady” in the words of one regulator, and should have required Fed approval. But the regulators basically accept Goldman’s explanations without a fight.

The sleuths at the ProPublica website, working with a crack team of investigators from public radio, also seem to think they have another smoking gun in one of Ms. Segarra’s conversations that was not recorded but was confirmed by another regulator. Ms. Segarra reports that she was shocked to hear a Goldman employee say that once clients are wealthy enough, certain consumer laws don’t apply to them. Ms. Segarra says she was told by a fellow Fed regulator after this conversation, “You didn’t hear that.”

In this case it appears a regulator was helping Goldman even when Goldman didn’t need any help. That’s because the securities laws have long sought to provide the most protection to investors of modest means. For example, a company offering securities is exempt from some registration requirements if it is only selling to accredited investors, such as people with more than $1 million in net worth, excluding the value of primary residences.

The journalists have also found evidence in Ms. Segarra’s recordings that even after the financial crisis and the supposed reforms of the Dodd-Frank law, the New York Fed remained a bureaucratic agency resistant to new ideas and hostile to strong-willed, independent-minded employees. In government?

***

Enter George Stigler, who published his famous essay “The Theory of Economic Regulation” in the spring 1971 issue of the Bell Journal of Economics and Management Science. The University of Chicago economist reported empirical data from various markets and concluded that “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.”

Stigler knew he was fighting an uphill battle trying to persuade his fellow academics. “The idealistic view of public regulation is deeply imbedded in professional economic thought,” he wrote. But thanks to Stigler, who would go on to win a Nobel prize, many economists have studied the operation and effects of regulation and found similar results.

A classic example was the New York Fed’s decision to let Citigroup stash $1.2 trillion of assets—including more than $600 billion of mortgage-related securities—in off-balance-sheet vehicles before the financial crisis. That’s when Tim Geithner ran the New York Fed and Jack Lew was at Citigroup.

Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can’t be gamed by the biggest firms and their captive bureaucrats. This means repealing most of Dodd-Frank and the so-called Basel rules and replacing them with a simple requirement for more bank capital—an equity-to-asset ratio of perhaps 15%. It means bringing back bankruptcy for giant firms instead of resolution at the discretion of political appointees. And it means considering economist Charles Calomiris’s plan to automatically convert a portion of a bank’s debt into equity if the bank’s market value falls below a healthy level.

Fifty years ago, Stigler described academics in a way that might also apply to much of today’s press corps: “The economic role of the state has managed to hold the attention of scholars for over two centuries without arousing their curiosity.”

GS4