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Barataria: 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.

This post was written by Erik Hare and originally published on Barataria. Follow Erik on Twitter: @wabbitoid.

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