Corrupting risk on top of the surplus pyramid

The voices in the City clamouring for the Pound to be kept strong got what they wished.

But the consequences for the real economy were devastating; production fell by 22% between 1918 and 1921. The real value of debts rose and rose. The exchange rate was far too high and so our goods struggled on world markets. On some measures in 1931, our per capita GDP was lower than it had been in 1915.

No wonder Churchill made his lament about wanting industry more content, finance less proud.

That was pushing risk downwards with a vengeance.

Let us consider what "too big to fail" means. It means someone who borrows too much to buy a house can go bankrupt, but the institution which lent too many such people too much money cannot. It is a classic example of pushing risk downwards.

It is also a profound subversion of commercial society, which Milton Friedman liked to point out was a profit and loss system:

You must realize that what we have is not a profit system; it's a profit and loss system. The loss part is just as important as the profit part. What distinguishes the private system from a government socialist system is the loss part. If an entrepreneur's project doesn't work, he closes it down. If it had been a government project, it would have been expanded, because there is not the discipline of the profit and loss element. If you have a really good idea, it may work. But remember, you're gambling. That's what makes it exciting, and that's what makes it important. What rules out the mistakes is the possibility of making a loss.

To put it another way, any social system generates "barnacles"--resource-consuming social nodes that undermine the overall operation of the society. It is undermining or lacking a barnacle-removing process which is fatal to a social system.

But it can be very attractive to be a social barnacle. To be insulated from loss is a massive and corrupting privilege. To be insulated from loss while being massively paid for managing risk is offensive exploitation of the weaker.

What happens when the IMFmoves in to do "structural adjustment" when a developing country has got into trouble from debt loaded on the polity but skimmed off within its elite? The risks are pushed downward. Debts which were allegedly to increase productive capacity get expropriated. The people best placed to assess the likelihood of that bear little or no risk from it (due to the IMF), so the risk gets loaded on to those who were not there (nor seriously represented) when the debts were negotiated and have little or no capacity to object or block expropriation. So the debt is loaded onto the ordinary folk of that society, but those who stole it get away with it and those who lent to those who stole it have the impact on them minimised. (The UN Convention Against Corruption [UNCAC]'s asset recovery provisions represent, in effect, a regulatory attempt to deal with the problem of corruption--including to block debt diversion by kleptocratic elites--and none too soon.)

Forcing ordinary taxpayers to repay stolen debt is a fairly vile worship at the altar of financier privilege. The notion that the claims of high finance are so much more important than any other consideration. Claims whereby huge salaries and bonuses are paid, justified by management of risk which is pushed off on to taxpayers and those lacking such political clout. Which, as the UK experience in the 1920s showed, can be entire industries and workforces.

There is a kernel of truth in the claims of high finance. It is important that credit keep flowing. If the flow of funds completely freezes up, massive economic harm can be done.

But, and it is a very big but, the point of supplying that credit is to manage effort across time and the risks thereof. The point is to allocate the risks to those best able to manage them, not those least able to avoid them. If those lending funds to developing world rulers are not taking any responsibility for monitoring whether those funds are likely to be spent in way which will increase the capacity of the polity to pay back the loan, they are acting in a way strikingly different from how someone getting a mortgage or a business loan is typically treated. There, your capacity to pay, the use of the loan, matters a great deal; the asset is managed in a more typical commercial style. Hence UNCAC attempting to deal with what financiers have consistently refused to take responsibility for.

Of course, the rise of complex derivatives in the US mortgage market meant lenders were not doing that traditional role of carefully assessing use. But the model of not paying attention to the realities of use of the loan was already established in the sovereign debt market. With a similar justification in both cases--taxpayers would always be available to pay it back, house prices would continue to rise, so systematic downside risk was insignificant.