Arnold Kling  

Risk-averse Risk Takers

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Morning Commentary... Attention Hoosiers...

Felix Salmon writes,


Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it's easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they're low-risk, even if they're full to bursting with enormous amounts of tail risk. The answer, as I've said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt.

Read the whole thing. Pointer from Megan McArdle.

What Felix omits in his short post is the unwilling risk taker known as the taxpayer. A lot of the trick of investment banking is to figure out a way to transfer risks to taxpayers. And the investment bankers have gotten really good at it, particularly in the last thirty years. That is why there are those of us on the right (Russ Roberts and myself, to name two) and those on the left (Simon Johnson and James Kwak,, to name two) who are skeptical of the incumbent regulators when they say that they can control moral hazard. Our view is that the moral hazard problem is much more profound than the regulators acknowledge.

Another really profound issue, which Salmon raises, is why so many people prefer debt-like contracts to equity-like shares in enterprises. If he were to read This Time is Different, by Carment M. Reinhart and Kenneth S. Rogoff (and perhaps he already has), Salmon would have even more reason to raise this issue.

My theory is that people have the illusion (and again, government policy can foster this illusion and sometimes make it come true) that they will not be victims of default. Every individual thinks, "Of course, if I see trouble coming, I'll be able to get out (or be bailed out) before I take a loss." When a default occurs, somebody will be left holding the bag. However, as individuals, none of us believes that that we are going to be the bagholder.

Another theory I have is that governments take advantage of these individual beliefs in the safety of debt. People treat government debt as risk-free, even though it clearly is not, as Reinhart and Rogoff remind us.

Those of us with U.S. government debt in our portfolios right now are just asking to be bagholders. Maybe Congress will stop spending so much, and the debt will be paid off out of taxes. Not bloody likely. Maybe we will see rapid inflation, in which case the holders of non-inflation-indexed debt will suffer a partial default (getting paid back in cheaper dolars), and the holders of indexed Treasuries will escape unscathed. Maybe there will be a capital levy, and all of us with financial assets will have a proportion of them confiscated. Or maybe the government will decide that printing money or enacting a capital levy like a Banana Republic are actually less politically acceptable options than just paying bondholders 50 cents on the dollar.

Have a nice day.


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    I commented last week on a blog post by leftist Aussie economist John Quiggin , who blamed the financial [Tracked on October 10, 2009 7:55 PM]
COMMENTS (8 to date)
Gary Rogers writes:

So why do so few people see this? It seems so obviously true.

Floccina writes:

Another really profound issue, which Salmon raises, is why so many people prefer debt-like contracts to equity-like shares in enterprises.

1. In 2007 the yields on debt were higher than the yields on stocks. The Vanguard Total market fund was yielding less than 1.5%.

2. For most equities there is no stick to force management to ever pay out any of the companies income to the shareholders and people do not trust corporate managers.

dWj writes:

About 5 years, I heard a comment about banks that they had made a lot of adjustable-rate loans, and while they weren't making a lot of money off of them then, that when interest rates went up the borrowers would pay the banks a lot more. "Unless they don't," I filled in, but they didn't seem to be thinking this way.

dWj writes:

Apparently I blogged that comment; it was April of 2004.

winterspeak writes:

Arnold: Here are the financial transactions that go into a Government debt purchase. Will you please tell me what problems the Government will have in reversing them, since you continue to assert that there is "risk in Government debt".

1. You write a check to the Treasury. When the check clears...
2. The Fed debits your checking account, and debits the banks reserve account.
3. At the same time, the Fed credits your Treasury account and credits the Treasury account at the Fed.

So, your account is debited, and the Fed moves a number from a reserve account to a Treasury account. To reverse this, your account is credited, and the Fed moves the number back from the Treasury account to the reserve account.

You'll note there are no taxes, or chinese, or anything involved in this transaction. So, please tell me what the issue is.

drscrooge writes:

the government is really limited to how it can default on its debt. the death of lehman caused a panic in the money market funds. imagine what an explicit default of treasuries would do.

Max writes:

Any whiff of credit risk in government bonds would create severe economic problems, so it's not in anyone's interest to go down that road. And it can always be avoided by some combination of taxes, spending cuts, and monetization.

winterspeak writes:

drscrooge & max: Please explain to me how it is possible for the US to default on Treasuries.

Here, operationally, is what happens when Treasuries are bought:
1) Federal Reserve bank debits its reserve account and credits the Treasury account. This is like transferring money from your checking account to your savings account.

Here, operationally, is what happens when Treasuries are sold:
2) Federal Reserve bank credits its reserve account and debits the Treasury account. This is like transferring money from your savings account back to your checking account.

That's it. A number goes from one row to another row in a spreadsheet. Where is the risk?

Thanks!

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