With financial alarm bells sounding, most of the nation -- including the country's business and political leadership -- has woken up to a forgotten truth: Government plays a vital role in managing risk. Since the start of the economic crisis, federal officials from both the Bush and Obama administrations have gone to extraordinary lengths to contain a mounting systemic threat, committing in excess of $10 trillion for ad-hoc financial rescues, emergency federal guarantees, and fiscal stimulus. Inaction in the face of a calamity of this magnitude would have been unimaginable, not to mention politically suicidal.
There has naturally been a great deal of debate about whether these policies will, in fact, revive the economy. But it's equally important to ask what comes next, once the alarm bells stop ringing. When economic growth eventually resumes and life returns to normal, will we be lulled back to sleep by the same soothing rhetoric of financial deregulation and risk privatization that helped get us into this mess in the first place? If so, the repercussions could be even more severe.
Risk has never been an entirely private affair in America. From the earliest days of the republic, government at all levels has actively intervened to regulate and reallocate risk. Congress passed the nation's first bankruptcy law as early as 1800 (in response to a sharp economic downturn), and New York state lawmakers enacted the first statute allowing general limited-liability incorporation in 1811. Nearly 200 years later, after the adoption of risk-management policies ranging from workers' compensation and Social Security to deposit insurance and federal disaster relief, we now devote more public resources to managing economic risk than to any other task, including national defense.
For those who doubt the value of such policies, just try to imagine what the world was like without them: the reality of debt servitude for failed entrepreneurs before bankruptcy law; the paucity of passive investment before limited liability; the scourge of recurring bank panics before the Federal Deposit Insurance Corporation (FDIC); the pervasive fear of destitution in old age before Social Security; the countless consumer injuries (including thousands each year from exploding soda bottles!) before the advent of modern product liability law and product-safety regulation.
Yet by the 1980s and 1990s, many of the benefits of these policies were increasingly taken for granted, and it became fashionable to highlight the costs instead. Critics mocked the creation of a "risk-free society" and a "nanny state." Indeed, such views complemented the market fundamentalism that was similarly in vogue at the time. Before long, the conventional wisdom in Washington was that risk ought to be left almost entirely to the private sector. Bailouts and guarantees of all kinds were to be avoided, Social Security privatized, liability law scaled back, bankruptcy tightened, Glass-Steagall repealed, and so on. Meanwhile, as new risks emerged, including those associated with sub-prime lending and securitization, many of our political leaders were apparently too busy trying to reduce the government's risk-management footprint -- and too seduced by the logic of laissez-faire -- to pay attention.
The problem with the risk-privatization approach, which took Washington by storm, is not just that it overlooked the remarkable success of many of the policies it sought to dismantle. It also ignored the new politics of risk in America that made do-nothingism an impossibility -- and worse, a dangerous charade.
In 1887, after Congress passed a bill to assist the victims of a severe drought in Texas, President Grover Cleveland vetoed the measure, declaring, "I do not believe that the power and duty of the General Government ought to be extended to the relief of individual suffering. ... Though the people support the Government, the Government should not support the people." Such a statement would be unimaginable from a president today. Over the course of the 20th century, most Americans came to expect that the government would help pick up the pieces in the aftermath of disaster, and massive federal relief in the wake of catastrophes (both natural and manmade) soon became a foregone conclusion.
Critics of disaster-relief programs and other forms of public risk management regularly raise the specter of moral hazard -- that individuals and firms will engage in riskier behavior when insured against major hazards. Unfortunately, the pretense of laissez-faire in good times, combined with the inevitability of aggressive government action in bad times, makes the moral hazard far worse, not better.
Although we still have much to learn about how the government should (and should not) manage risk, one lesson from the historical record is already apparent: Most of the best risk-management policies -- from limited-liability law to the creation of the FDIC -- have built-in mechanisms for monitoring and controlling moral hazard. In the case of limited liability, which shifts risk from shareholders to creditors, the creditors themselves have a powerful incentive to monitor the corporations to which they lend. In the case of the FDIC, bank regulation is an essential complement to bank insurance, providing the sort of risk monitoring and oversight that, in an ideal world (and in the absence of federal insurance), depositors might have provided themselves.
In fact, it was precisely by deregulating the savings and loan associations while increasing their insurance coverage in the early 1980s that lawmakers essentially guaranteed the subsequent S&L disaster. Today, we risk making a similar but much larger mistake with respect to the broader financial sector -- effectively offering insurance (through the Treasury, the Federal Reserve, and other federal agencies) without accompanying regulation to manage the moral hazard.
As a starting point, proper regulation would include stringent capital and liquidity requirements for all systemically significant ("too big to fail") financial institutions, reasonable restrictions on these institutions' overall leverage and contingent liabilities, and a new FDIC-style receivership process for these very same institutions to facilitate liquidation or restructuring, rather than unending federal infusions, when they are on the verge of failure. Some sort of federal capital-insurance program, where both premiums and potential payouts are well defined in advance, might also be required.
Particularly now that the government is viewed almost universally as an insurer of last resort in tough times, it's the height of irresponsibility to pretend (contrary to the nation's own historical experience) that we should leave risk solely to the market in good times. We've received our wake-up call. The challenge now is to remain alert, even after the current crisis passes and the familiar soporific rhetoric returns.
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