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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