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Socialized Risk

Risk and reward management are the heart of any investment.  Money goes into ideas and efforts that have a chance of paying it back with a little bit of profit at the end.  If risk is completely removed anyone will make decisions and try things that they might not have otherwise.  When the risk is spread out to people that they don’t know or necessarily care about, disaster is pending.

That’s pretty much what just happened to our economy – socialized risk with private profit.

Supply-side theory, where investment money is made as cheap as possible, is about reducing risk to investors. Whenever money can be borrowed cheaply it will find its way into investments that otherwise would be considered too expensive to be worthy investments.

This kind of policy is supposed to pay for itself by fueling a high level of growth that will bring in more revenue later. This is the “Laffer Curve”, named for economist Arthur Laffer, who has extensively analyzed when and where cuts in marginal rates to investors has worked.  When taxes on investment get too high it is entirely possible to stimulate growth through the economy as a whole by cutting rates, as he has shown.

There are two problems with this analysis, however.  The first is that it does not mean that always cutting tax rates for investment will help fuel growth, as acknowledged by Laffer himself – there is a time and a place for everything.  The second problem is deeper and shown by two times when Laffer gets to crow that his theory worked – the mid 1920s and the late 1990s, times that mark the start of massive credit bubbles that ended with a Depression.

This naturally leads itself to the other side of a cheap money policy, the part where deregulation of banking is considered always good.  The creation of large banks clearly makes money cheaper, encourages investment, and thereby increases the total risk taken on by the entire system.  When their failure is not an option, risk is directly socialized by a bailout – as we saw in 2008.

Supply-side policy is only one aspect of socialized risk, however.

The Black-Scholes-Merton theory dealt with risk directly by, at least in theory, eliminating it.  The concept is simple – any investment can be insured by selling contracts that pay off if it fails, pushing the risk out to a larger market.  This is what we call a “Credit Default Swap” (CDS), which is a kind of “derivative” – a financial instrument that pays off based on some other purely financial event.  Set a big investment up properly and, the theory goes, you can be guaranteed risk-free return.

Without getting into the impressive math that makes this otherwise batty idea look smart, there is a major limit to the application of this work – it assumes a stable, liquid market that does not have a major disruption.  As long as everything keeps on keepin’ on it is possible to eliminate risk in a truly peaceful world.

The application of this work met the supply-side movement in the late 1980s, and you can imagine how the two worked together.   When money can be had for cheap and invested at no risk there is only one thing to do – borrow as much as possible and leverage as many investments as you can.  That’s how the total global market for derivatives reached $516 trillion in June of 2007.  This is not a typo – $516 trillion, or nearly 10 years total world production of everything.

The risk, of course, did not go away – it became socialized risk, borne by the system itself and ultimately governments.  The massive credit bubble that created and defines this Depression was formed by far too much leverage –  Other People’s Money (OPM) – the real opium of our time.  That is what socialized risk is.

It may not set well with some to call risk that is distributed through market forces a socialized risk, but there is no better term for it.  If the risk is not carried by the investor it is shared socially by some mechanism.   There is a government policy pushing the concept at the front and an implied bailout at the back end that distorts the market.

There are some who look at the system of socialized risk and demand that rewards also be socialized by either nationalizing the banking system or, at least, regulating it as if it is a public utility.  The other option is to understand how supply-side theory is socialized risk and ditch the entire concept, at least as it is dogmatically applied to every situation in every economy.

Either way, I’m good with it.  The system we have now, of socialized risk and privatized profit, has shown itself to be a failure.

43 thoughts on “Socialized Risk

    • Thanks. I hope that fellow Democrats can pick up on this – I’m doing my best to get towards a slogan that’s useful. Not quite there yet, but close.

  1. as long as the rich control politics and the media the rich will get their way – they will get the 99% to pay everything to them one way or the other – theories are only tools to manipulate the population into thinking there is some great mast plan other than stealing everything they can

    • Welcome! You know, there are zillions of theories out there, but the one that tells the owners of media and so on “You can have your cake, eat it, and eat your neighbors’!” is the theory that will have a lot of traction – no matter how stupid it might be. So yes, that’s the way it goes when you trust “experts” to run everything.

  2. I don’t know how anyone can support the idea that cutting taxes on the wealthy creates jobs, which is what you hear repeated over and over these days rather than supply side which I think lost its favor. I certainly don’t know anyone who thinks that is true and the more the media repeats that or allows it to be repeated the lower their credibility in my book.

    • You’re right, the term lost favor. I’m using it because I can’t think of any other term for the whole theory that launched this mess. My guess is that it started playing badly as a term in the 90s and the Republicans deliberately dropped it. I still prefer “Voodoo Economics”, but I’m old. 🙂

  3. Yet even some SUPPORTERS of these theories have been known to state:

    “This is a consumer-driven economy.”

    All the while supporting job-cuts for “profits.” The mind boggles!

    • Exactly. I left the door open a bit for the possibility that there are times when investment cash is short and cutting marginal rates on capital gains really is a good idea – I still think the main effect of Reagan’s tax cuts in the 1980s was a Keynsian stimulus but I’ll let that one go because the fight is not relevant at all. But no one can claim this is what needs to be done today. It just doesn’t make a lick of sense.

  4. Numbers fly all over the place & I appreciate you keeping it number free mostly. But $516,000,000,000,000 in derivatives? holy shit!

    • Welcome! While I never swear, I don’t mind if commentors do, at least when it’s appropriate. And $516 trillion, as you wrote it out (counting the zeros … check!) is worth swearing about.
      There are times when something is so stupid that you have to think there is a dark, evil purpose behind it. The way the whole party got out of whack I’d say it was so evil that things went way back over to just plain stupid. There is no way the worldwide derivative position could possibly have ended well in 2007. The truth is that this is the low estimate – some have been as high as double that, and no one is really sure.
      Have a nice day! 🙂

  5. This is a political rejoinder to today’s blog.
    I want to ask the question why did Democrats become Reagan Democrats. In the heartland of the country, the midwest, people who had voted Democratic up and down the ticket since 1932 started to split their ticket. In Illinois in 1984 for example people voted for Paul Simon for US Senate and for Ronald Reagan. The political system can not digest that bifurcation. What we get is that the left and right activists become very frustrated. As you will recall Paul Simon was a candidate for US president in 1988. Gary Hart ran on new ideas. The new ideas included that that Democratic Party was too liberal, foretelling the rise and presidency of Bill Clinton. From a policy standpoint higher taxes make sense. But the American Revolution permanently made Americans skeptical of federal government. That is, until the Great Depression. The simplest way to deal with private profit is to tax it. But as I’ve said it I support higher taxes after the economy recovers. How we get there I’m unsure. Maybe Paul Simon and Jack Kemp know.

    • I want to ask the question why did Democrats become Reagan Democrats
      I dunno … you do your best to raise the kids up right and … sob!

      Seriously, it's a good question. I was a big Paul Simon fan (and not just because bow ties are cool) but because he represented what I always have believed – you set up the system to fairly reward hard work & smart thinking, but in a way that takes care of the vulnerable. The rest you sort of let go once it's off and operating, until you see a problem – when you go in and fix it.
      Sadly, Paul Simon is dead. jack Kemp? Dunno, haven't heard from him in a while (tho I still have a #10 Buffalo Bills bobblehead from the late 60s around somewhere). We're just so timid about everything substantial any more.

  6. I like to think in terms of grand compromises. I would favor nationalization of the banks in exchange for a major reduction in entitlement benefits. As a conservative centrist I think that loosening the political and policy logjam begins with entitlement reform. The reason is that we can not finance the retirement benefits of baby boomers and beyond and this is recognized by most except Democrats.

    • That would be an interesting compromise – might have to throw a few other things in there in the way of reform but I think what counts is moving forward. So much is changing that I’m afraid that we aren’t in a position to master the world being created around us and will instead be mastered by it.

      You’re right about entitlement reform, and I’ve been slow to take that on because I’ve focused on the immediate problem of the Depression. But you’re right, at some point we have to do something about it. I’ll think about it.

  7. What I can’t understand is how the rich got away with this. If the democrats came up with a complicated theory that goes against common sense they are laughed down. How do the republicans get away with it?

    • Sheryl: It is a strange thing, isn’t it? The idea that the rich create jobs THEREFOR we should give them more money is a two-step process, one that has big “maybes” at each step. But it seeped into the political dialogue in a way that it just can’t e dislodged. Dunno.

  8. How about “Defense Entitlement Reform?” We spend more on defense than the next eleven countries COMBINED. Oh…neither party is willing to go there…jobs in their districts. 😦

    • We spend more on defense than the rest of the world combined, or nearly so. I think that’s what the Dems should trade for entitlement reform, the more I think of it. I once calculated that the roughly $720B we spend on defense (no one is entirely sure what the various wars are costing us) coube be cut by 1/3 and we’d still be at an inflation-adjusted level equivalent to 1988- ie, the height of Reagan’s Cold War binge.
      So there – that’s the trade-off for a Grand Deal that involves entitlement reform – and possibly tax reform as well. We could easily get ourselves to some serious deficit reduction in the process as well.

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  27. I really like how you extend the idea of socialized risk to include monetary and regulatory policy. I had been using that term about bailouts and such but you are very correct than any risk not carried by the investor is socialized risk.

    Also you mention that you were trying to come up with a slogan. Maybe something like “Socialized risk and privatized profit is not capitalism” or “Socialized risk means the poor pay for privatized profits”.

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