From Five Ways of Looking at Risk.
Recent discussions of the malfunction of Wall Street have centered on the role of statistical models that failed to accurately account for all possible outcomes. These less likely results, known as "tail risks," were underestimated by the models. Now the "quants" on Wall Street and academia have a new research agenda, which is to figure out how to fix those models.
Telling the story in this way has a risk of its own. Focusing on inanimate abstractions and numbers diverts attention from the human conflicts and follies embodied in our current catastrophe. The challenges related to the distribution and management of risk are much more formidable than a technical fix because they are not technical problems. Managing and balancing risk in the future is an organic human problem, a political problem, and a problem of power. The question is how to remedy the fact that some players have the power to shift risks and to use the political process for insurance, while others do not.
Risk is inherent in the world. Natural disasters, wars, famines, floods, as well as the business cycle and disruptive innovations all introduce risk into life. A properly functioning capital market, working together with government, serves to diversify and distribute that risk to those who can bear it. Social institutions are set up for collective support for the aged and weak and those who fall prey to natural disaster. We've forgotten that in recent years, when society was caught up in the urge to be "entrepreneurial" and to show a hearty appetite for risk. Declaring oneself a "risk taker" was a badge of honor.
We undermined the public institutions constructed to bear risk and insulate citizens from the worst consequences. Health-care policy treated patients as empowered consumers, ignoring their fundamental vulnerability. (Most people heading to the emergency room are not focused on comparison shopping among providers.) Congress cut back on bankruptcy protections for individuals. At the same time, unemployment insurance, welfare, and other aspects of the social contract were charged with creating a disincentive to work. When it came to institutions that protect individuals, concerns about moral hazard were rampant in the economics departments throughout the land. To be sheltered from risk was to be weak or corrupt.
Unfortunately, all this concern about perverse incentives of the weak and unfortunate was not applied in the world of finance. Free-market fundamentalism dominated academic and political debates. Regulations and restraints on the behavior of financial institutions and investors were seen as inefficiencies and unnecessary constraints, getting in the way of greater and greater financial efficiency.
In these elaborate intellectual portrayals of the financial marketplace, little attention was paid to the well-known fact that if a financial crisis were to emerge, officials would step in to truncate the risk of the downside in the name of containing "systemic" consequences. Systemic consequences mean spillovers from the financial sector to the real economy. In this case, just as drivers in an era of cheap gasoline don't worry about the costs of climate change, private participants in the financial system were not pricing the societal consequences of the risks they were taking.
It is important to note that the problems of financial excess introduced risks into society that need not be present. Factors such as excessive leverage, balance sheet complexity, and executive incentives that encouraged risky behavior fostered a system that did great and unnecessary harm. The financial sector did not merely transfer risk onto the taxpayers. It greatly amplified the risk, and took out large bonuses, before handing the bill to the victims across the national and world economic landscape. It is tragic that at the same time we subjected many to the sharp edge of unavoidable risks by weakening social protections, we fanned the flames of risk amplification by the powerful, using the promise of public money to give them a sense of invulnerability.
Previous events enabled market participants to know that the downside of their risks would be limited. The Mexican bailout of 1994?1995, the Asian Crisis of 1997, the Greenspan rate cuts in 1987 and 2000?2001, were all examples. In each case, putting out the immediate fire was imperative. But as time passed each "success" pumped more confidence into the financial balloon.
The underwriting of downside protection, which has been called the "Greenspan Put," owing to former Federal Reserve Chair Alan Greenspan's willingness to cut interest rates and provide assistance to the financial sector, was accompanied by the fierce campaign to unshackle market participants via deregulation. Economists selling expertise were rewarded by patrons who were making money, and together they convinced our money-hungry political representatives that they were doing good for society by accepting campaign contributions to remove constraints on finance. A fawning media offered little resistance.
Then suddenly, it all came to a crashing halt. Now we are in the middle of a process of de-leveraging, a system-wide reduction of risk on the balance sheets of financial institutions. The government, in order to mitigate the excesses of the highly leveraged, poorly managed, exceedingly complex financial sector, has itself become highly leveraged. It has created its own intricate structures, all devoted to keeping intact the very large "too big to resolve" institutions that are responsible for the crisis.
What we have seen so far is not a new approach to risk but risk transfer. Risk is being transferred from the balance sheets of financial firms to the public, by elected representatives from both parties. Think of lobbying and campaign finance as an insurance policy for finance. For a small premium, the financial firms bought the right to offload their losses after they occurred.
Even after the crash, the human dimensions of risk and the incentives to take it on are unchanged. Each of the big financial firms has the incentive to shift risks by selling assets to raise capital before the other goliaths do. Each has the incentive to scurry to the back of the bus and make sure that other firms get "resolved" before they do. If Citigroup were resolved, then everyone else's balance sheet would be stronger. The American International Group bailout turned out to be a conduit for strengthening the firms with which AIG was intertwined.
Although the crisis is systemic, an equally comprehensive resolution may prove impossible. The firms that were strongest politically, notably Goldman Sachs and JP Morgan, were betting that the others would be brought in and restructured first. As this tug of war played itself out, the size of the crisis and the damage to the economy deepened. This dysfunction did not merely transfer the hot potato of risk from one firm to another; the delay in comprehensive resolution actually increased the amount of risk society was forced to bear--the potato got bigger and hotter.
Only the most powerful and wealthy can afford to play this game of risk transfer. The Consumer Education Foundation, in a recent report titled "Sold Out: How Wall Street and Washington Betrayed America" estimates that U.S. financial, insurance, and real-estate firms paid about $5 billion in combined lobbying and campaign contributions over the last decade. They will likely offload nearly $2 trillion in losses onto the taxpayers, so their political investments have paid off at nearly 400 to 1. Goldman Sachs alone recovered its estimated $47 million dollars of influence-buying in one fell swoop with the over $12 billion dollars of transfers reported in the AIG bailout. Even if half of that were justified recovery, the return on their political investments was more than 13,000 percent!
In the future, how can we reduce the incentives and the ability to shift risk, first onto other firms and then to the public? The public good of trust has been badly shattered by the brazen demonstration of power in this episode, and while government has grown, our capacity to believe that government can address and solve social problems, once inspired by the actions of Franklin D. Roosevelt and then denigrated from Ronald Reagan to the present, may be diminished.
It is possible that the current financial and economic crisis will be viewed, in the hindsight of history, as an outlier, a tail risk in itself. But to prevent similar crises in the future, we have to think of risk not as a problem of faulty math but a problem of power. The solutions will not be found in academic finance but in reforms to campaign finance, lobbying, and tax law that create a government that can stand up to the natural human inclination to take on risks and then pass them on to others.
