Economix - New York Times Blog
September 11, 2009, 7:00 am
By Uwe E. Reinhardt
With the anniversary of the failure of Lehman Brothers
approaching, we asked each of our Daily Economists to share some lessons
learned from the financial crisis. Here Uwe E. Reinhardt, a Princeton economics
professor, responds. Find the rest of the series here.
A year ago, century-old Lehman Brothers lapsed into
bankruptcy, completely spooking the oligarchy that runs our nation’s financial
sector.
The oligarchs had fully expected to see Lehman bailed out by
the federal government that serves them, especially after the government had
dutifully bailed out Bear Stearns earlier in the year. When Lehman was not so
served, panic set in, unleashing global economic turmoil and pain.
Devastating as this calamity has been to many individuals and
institutions, it should have served Americans also as a great teaching moment,
reminding them of the important and highly productive role government risk
management plays in their daily lives.
The financial markets had prided themselves on their expertise
in pricing and managing financial risk prudently. But left on their own, they
proved that they could not even manage properly as simple a transaction as a
mom-and-pop mortgage loan, let alone fancy derivatives such as the
collateralized debt obligations (C.D.O.’s) that were based on sloppily-written
mortgage loans and the credit-default swaps (C.D.S.’s) meant to insure the
value of these C.D.O.’s, but without adequate reserves to back up that credit
insurance.
In the end, like teenagers who hate Mother’s strictures when
all is well, but run to Mommy whenever they get in trouble, the swashbuckling
oligarchs of the financial sector ran to government for cover, owning up once
again to the time-honored mantra of this country’s legendary rugged individualists:
When the going gets tough, the tough run to the government.
Another term for “government risk management,” of course, is
“social insurance.”
It is a social contract with government that Americans
quietly love, but in the shouting matches that now pass for our “national
conversation” on public policy so often profess to hate — as when they cry for
government to stay out of Medicare, or when they sit on their beachfronts in
the Hamptons waxing worried about government intrusion in the economy, all the
while basking in the security of federal flood insurance.
After seeing the evaporation of so much of the wealth they
had imagined to reside in their 401(k) plans, mutual-fund accounts and private
pension plans, for example, millions of middle-class Americans surely must have
gained a renewed appreciation for one of the most popular social insurance
programs in American history: Social Security.
Indeed, for millions of middle- and lower-income Americans
of all political stripes, Social Security has become and will remain the main
source of economic sustenance in their retirement, along with two other popular
social insurance programs: Medicare and Medicaid.
Social insurance is routinely called to the rescue also
whenever governors of all political stripes ask the federal government for help
after a natural disaster has struck their state. Along with direct financial
relief, the Federal Emergency Management Agency is an instrument of social
insurance.
It can be asked, of course, why that form of social
insurance generally is judged highly desirable — even by the most staunchly
conservative politicians — when so often they mistakenly decry as “socialism”
proposals that government come to the assistance of an individual American
struck by a natural disaster called “illness,” like cancer.
Perhaps the argument is that individuals should make their
own financial arrangements in the private market for risk management to protect
themselves against the financial risks of illness. But then it can be asked why
states in disaster-prone areas — e.g., Florida and other states along the Gulf
Coast — should not be required to tax themselves on a regular basis for the
purchase of private insurance to cover the cost of their fairly predictable
calamities, or to set aside adequate rainy-day funds to meet that cost.
Why is it the American way that I in New Jersey should feel
obliged to give financial help to a family whose beach house in Mississippi was
blown down by a hurricane, but it is socialist and un-American to help a
Mississippi woman struck by breast cancer?
One of the most thoughtful recent books on the topic of
government risk-management is “When All Else Fails: Government as the Ultimate
Risk Manager” (2004), by David A. Moss, a Harvard Business School professor.
The author clearly explains in this book why public risk management has become
an essential and very popular form of government intervention in modern societies,
including the United States, and even among its more staunchly conservative
citizens.
Professor Moss explains that the first application of social
insurance in our latitudes actually was aimed not at protecting individuals
against financial risk, but at supporting the growth of modern capitalism. Its
main instrument to that end was the legal sanction of the principle of limited
liability of the owners of corporations.
Prior to this form of social insurance, the owners of a
business were legally liable with their personal wealth for damages the
business might have inflicted on others. With limited liability, the
corporation’s shareholders are liable only up to their equity stake in the
company. They can lose at most the value of their investment in the
corporation’s stock. Beyond that, someone else in society — often the taxpayer
— bears the financial risk for damages attributable to the corporation.
One wonders how many business executives and members of
chambers of commerce around the country realize that the limited liability of
shareholders is social insurance.
The most pervasive form of social insurance for the business
sector in recent times, of course, has been the massive government bailout of
the financial sector following the Lehman Brothers bankruptcy. Without the huge
array of public assistance provided by the Federal Reserve, the United States
Treasury and the Federal Deposit Insurance Corporation — cheap loans in the
trillions from the federal government, trillions of dollars of loan guarantees,
and hundreds of billions of dollars in outright capital infusions — the
financial sector would have collapsed as a result of its own egregious failure
to manage and price risk properly.
One would hope that by now this lesson on the beneficial
role of government in risk management in our society has sunk into the minds of
the American public.
One must also hope that eventually it will penetrate even
the minds of economic theorists, who prefer to work in data-free environments
and who had logically deduced from certain axioms and behavioral assumptions
that private markets really, truly know how to manage financial risk.
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