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November 10, 2002
David Warsh, Proprietor


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Better Men and Better Women

Whatever is going on between Republicans and Democrats in America today has been going on since 1980. That’s when the election of Ronald Reagan set a political agenda for the US quite different from the program of Franklin Roosevelt’s “New Deal,” which the country had pursued since 1932. The late Robert Nozick called this the zigzag of American politics. The tendency is widely understood by American voters.

“The electorate wants the zigzag,” wrote the philosopher Nozick in “The Examined Life.” “Sensible folk, they realize that no political position will adequately include all the values and goals one wants pursued in the political realm, so these will have to take turns.”

For the Democrats, then, to have been cast into the wilderness actually may have been a promising development — in the long-term, anyway. Their situation now resembles that of the GOP after 1962, when John F. Kennedy won widespread approval for his program, having been elected in 1960 by a razor-thin margin.

Internal contradictions then split the Republicans. Arizona Senator Barry Goldwater, who had complained that there was “not a dime’s worth of difference” between the parties, was nominated as the GOP presidential candidate in 1964 — and then defeated in a landslide.

But Goldwater’s “choice not an echo” campaign against Lyndon Johnson turned out to be a vast learning experience for the Right. In its aftermath the GOP slowly built the coalition that has now governed for 25 years. (Reagan made his political debut in an emergency last-minute television address on behalf of Goldwater).

In short, while waiting for the 108th US Congress to take office next January, it’s a good time to curl up with a good book of financial history. One such is “When All Else Fails,” by David Moss. Democrats pondering how to rebuild their shattered party should read this book about the government’s role as risk manager. Republicans should read it too, since many of the issues it has brought to the table are illuminated here.

Risk management policy is one of the least understood of all the functions of government, says Moss, an historian and associate professor at the Harvard Business School. “Whenever you deposit money in an FDIC-insured bank or observe the speed limit or buy shares in a limited liability corporation, you are (whether you know it or not) the beneficiary of a risk management policy.”

Risk management takes many forms. Product liability laws and medical malpractice statutes seek to apportion risk among producers and consumers of goods and services. Bankruptcy distributes risks to creditors from entrepreneurs.

Federal disaster relief spreads the burden of catastrophic insurance over the entire population of taxpayers. Central banking distributes the risk to money itself that accompany the occasional panics to which the global monetary system is prone. Then there are federal guarantees of one sort or another — deposit insurance, pension insurance, mortgage-backed securities insurance and the like.

 

Industries, too, are sometimes offered federal bailouts of one sort or another because they are seen to be engaged in high-stakes competition — automobiles, the steel industry, the savings and loan industry, airlines and airplane manufacturers, to name only some of the most prominent. Starting in the1980s, whole countries were bailed out.

And of course there are the near-universal social insurance programs — Social Security, Medicare, workers’ compensation and unemployment insurance. The budget for these four programs alone exceeds $500 billion a year, Moss says — about a third as much as the Federal government spends annually on all its activities.

In short, “A nation widely-known for its anti-statist sentiments and its faith in limited government,” he writes, “the United States is nonetheless up to its elbows in risk management policies.”

Government’s entry into risk management is no recent development, according to Moss. A close look shows that politicians were underwriting improvising where private markets failed to materialize as far back as the dawn of the republic. Nor was expert advice ordinarily required. In general, policy-makers knew what they were doing. His economically-sophisticated history provides an idea backdrop to speculation about what is likely to happen next.

Moss divides the history of risk management in the United States into three broad epochs. The first phase sought to enhance security for businesses. It arose naturally from the promotion of manufacturing in the new nation in the 18th century and lasted most of 19th century. No measure taken then was more important than the advent of limited liability, which shielded owners of corporations from personal liability in the event their business failed.

Why should that make such a difference? The legal doctrine, which emerged in the course of Massachusetts’ competition with New York for industrial supremacy, didn’t cause the risk of default to disappear, notes Moss. It simply shifted a portion of it from shareholders to creditors. Sharing out responsibility brought about better monitoring of the risks actually undertaken. Strictly limiting risk to individuals encouraged more people to join in. A flood of business investment was the result. Other innovations in risk management included bankruptcy law, the rationalization of property rights and the maintenance of a fixed exchange rate, aimed at shielding businesses from currency risks.

Starting around 1900, the direction shifted. Security for workers moved to the fore, first in a series of workplace safety acts, then in the workers’ compensation laws that were enacted by the states in the decade after 1910 — all designed to persuade employers to take safety more seriously by shifting the money risk in their direction. Compulsory unemployment and old age insurance followed as part of the Social Security act of 1935.

But the centerpiece of the 1935 Act was, of course, its system of government pensions — big enough to constitute a genuine safety net for the elderly and the poor, popular enough with the middle class to command widespread political support. The Full Employment Act of 1946 added another responsibility to government’s risk-management duties — macroecomic stabilization.

A third phase began after 1960. Moss describes it as “security for all.” It was foreshadowed by the Meat Inspection and Pure Food and Drug Acts of 1906. But where just 6 percent of uninsured catastrophic losses were made good by the federal government as recently as 1955, the figure had soared to nearly 50 percent by 1972.

Personal risk became the target. Congress enacted Medicare and Medicaid, passed corporate pension reform, greatly extended consumer protection and moved swiftly to safeguard the environment. By the 1970s, “Security against catastrophic risk was fast approximating a new right of citizenship,” writes Moss. “Instead of redistributing income or capital as good socialists would, US lawmakers have actively redistributed risk, carving out a distinctive role for the state within the crucible of American capitalism.”

Needless to say, there was a backlash. Much of the politics of the last 20 years can be understood as an argument about how to come to terms with the occasionally perverse incentives created by the new risk-shifting systems. Moral hazard has entered our everyday vocabulary — meaning the propensity of arsonists, reckless managers, S&L looters, bad debt artists, welfare bums and other miscreants to advantage of the opportunities that are sometimes afforded by insurance.

A new emphasis on risk-reduction began to make itself heard, most notably in the highly-successful anti-smoking campaign. And economists made great strides in measuring and managing specific risks by creating markets for them. Now medical science has introduced a serious new challenge to the insurance mechanism.

“An increasingly potent rationale for the public management of health risk is not that private markets are function poorly,” write Moss, “but rather that they promise to function all too well, dividing us into ever-smaller risk pools in the face of a torrent of genetic information about our own personal predispositions to illness.” In that case, health care would become prohibitively expensive for precisely those who need it most — unless the government steps in to formulate broad new statistical communities.

Who can doubt that this is the reallocation and reduction of risk will be the fulcrum on which the much of the domestic politics of the next 20 years will turn? The biggest battles will involve fashioning systems of retirement income and medical insurance that have broad egalitarian appeal, but which appeal also to the well-to-do.

Creating better men and better women is the task at hand. It can only be done by those who begin with a proper appreciation of problem of moral hazard. In the zigzag of politics, the next turn belongs to those who succeed in reducing and reallocating risk without diminishing incentives to good behavior.

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