Managing Moral Risks: Private vs. Public

The world liquidity crisis has renewed the discussion over the public sectors intervention in the economy and the rise of moral risks associated with said intervention. The simplified and liberally against government intervention in the economy argument, says that it is preferable for financial institutions that abused the leverage boom and made bad investments to go bankrupt, rather than having the government come in and save them. They believe that the only form to teach us all the lesson about being moderate in what we do with credit, investment, and consumption, is taken us into bankruptcy if we haven’t been careful with our use of credit and selection of risk. If the kid wants to put his finger in the flame, let him, that way he’ll learn that the flame burns and he will never do it again.

The argument if favor of government intervention, to avoid a massive bankruptcy by abusers of the system, is that this bankruptcy would make just people pay for sinners. The way the just would pay would be through a global depression with job losses and massive impoverishment, which sadly, would hit the most vulnerable, that are not necessarily those that abused free enterprise.

Truth, as in many other of life’s arguments, is hidden a bit by all sides. I believe in the system of free enterprise. It is the one that encourages the most creativity of the argument and greater productivity and personal and collective satisfaction in the human community. What makes the human species so special is its capacity to innovate, and free enterprise promotes creativity and innovation. On the other hand, it is undoubtable that there are benefits to be found in diversifying collective risk through systems of domestic and international diversification. If we have to live in an island we die lonelier and quicker than if we depend on one another.

How much to depend on one another is a fundamental question. Children depend on their parents till they are 18 or 21 years olds (some more, others less). Parents depend on their children (some more than others) and it has been impossible to eliminate relative poverty, even though relative poverty has been greatly reduced in the last 10 years of a free and global economy. To let the banks fail in an economy is catastrophic because banks administer the payment system. Because of this, governments are forced to intervene when confidence in banks falls to a level where the credit and payments systems stop working. That is where we are today.

The government can and should intervene in order to reduce and diversify the risk in the system when the cost becomes high. Cost becomes infinite when all credit dries up. But when the cost of risk comes back to relatively normal levels, it is no longer necessary to distribute risk between the private and public sectors. Police protection and national defense are basic and permanent community risk reduction functions of the government. Most other risks shaving functions should be counter cyclical and on an exceptions basis. It is unforgivable when the public sector decides to increase social risk and its economic cost by intervening in the economy, when such an intervention is not necessary.

The Argentinean government has just announced plans to nationalize the private savings system, even though it is not in crisis and has allowed Argentineans to save for old age. That type of intervention is criminal and destructive because it does not reduce, but rather raises the risk exposure of all the country’s inhabitants. The risks of the Argentinean State are better diversified internationally and not confiscating Argentinean’s private savings.

Government intervention in the economy is only justified as an emergency mechanism to reduce short and long-term economic risks, but only as a temporary action and aimed at the return and regularization of supply and demand. Most government interventions in private banking is done to restore payments, credit and liquidity and is transitory and subject to disappear once markets stabilize.

The crisis also signals that the IMF’s capital must be increased many times and its governance and quota distribution modified to include more surplus countries, in order to help diversify global risk more efficiently than what each country can do individually. It is equally necessary to make sure that no financial intermediaries of significant size (“too big to fail”) can dip below banking standard capital adequacy ratios of 8-10%. It is time to establish more permanent mechanisms for the reduction of global risks.