There are several important insights we need to understand about risk and uncertainty. The first is that the risks associated with uncertainty are ubiquitous. We cannot eliminate the risk of life in this uncertain world. We can only manage it. Because we are loss averse, our incentive is always to reduce our risk exposure (all other things being equal). We can increase our risk exposure, and we often do so in search of higher rewards (like the bettor or the jockey in our example), but we cannot eliminate the fundamental risks of an uncertain existence. Accidents do and will happen. We have little control over whether our industry succeeds, allowing us to keep our jobs. Our attempts to avoid these risks usually only shift those risks onto someone else (see explanation below).
The second insight is that there is only one way to manage uncertainty. This is demonstrated by nature through diversity and diversification. Diversification is the survival imperative of biology. Similarly, we humans diversify with our skills, education, and also with our asset portfolios. This is why financial advisors tell us not to "put all our eggs in one basket."
The science of risk is based on the theory of probability. We can calculate probabilities of chance that allow us to price the risk of loss and then pool together independent events to protect us against possible loss. This is the logic of the insurance industry. We pay insurers a premium based on the small probability of loss, like a house fire or accident, which only pays off if we suffer the loss. The insurance pools all these premiums based on the probability of an event occurring and charges enough to cover the losses and yet still allow for a profit. Since one house burning will not likely cause other houses to burn, the events are independent and the insurance company will use the premiums of all the insured to pay off the loss of the one. (They also invest premiums and realize returns before they ever have to pay out, which helps them enhance their profits and keep premiums down.)
We can also manage our risk exposure by hedging, counterbalancing one risky gamble with another that will pay off if we lose the first. This is really just another form of diversification, as it seeks two actions that respond to events in opposite ways. This is a common financial strategy that has given its name to an entire industry.
Diversification is the foundation of portfolio theory that we employ for pension and retirement funds. While we may diversify our human capital by acquiring skills and education, it is much more effective to manage unknown risks by accumulating diversified real and financial assets, such as houses, fine art and collectibles, precious metals, and financial assets that are spread geographically and also across industry sectors. The explosion of financial markets around the world and the innovations in financial instruments has now made this diversification possible for the average citizen investor.[34]
It is important to note, as stated above, that the diversification model only works if contingent events are independent. Dependent events, such as a hurricane or an earthquake, which hits all the houses in a neighborhood at once, create major losses for insurance diversification models. This is why it is often too costly to buy such insurance if, and where, you need it. More seriously, the interdependence of world financial markets has impeded diversification efforts. The risks associated with financial contagion are increased when all financial markets collapse at the same time. Incomplete insurance markets have been served by government-directed social insurance programs like Social Security, Medicare, and unemployment and disability insurance. More on these later.
The efficacy of insurance also depends on the behavior of the insured. If auto insurance causes a driver to drive more recklessly, then the insurer's calculation of the risk probabilities will be wrong, leading to losses for the insurer. This is called moral hazard, and can be a costly problem for insurance. Moral hazard also afflicts social insurance. Social Security can cause people to save less for retirement, or subsidized health care may cause people to be more cavalier with their health.
Our third insight is that risk is a negative good (i.e. we will pay someone to take it away from us). For someone to buy that risk there must exist the promise of a possible return (we don’t bet on horses if there is no possibility of winning). So when risks are shifted from one party to another, say from you to the insurance company, the payment of a return associated with that risk (the annual insurance premium) goes with it. This return-risk relationship is the first law of finance: the higher the risk taken, the higher the reward (or the potential loss). The lower the risk, the lower the potential reward or the potential loss. This is called the reward-to-risk ratio, or the risk-adjusted rate of return. It's not difficult to observe this relationship in almost every risk-taking decision we make. As with our previous analogy of the roulette table, the tendency toward equalizing the reward-to-risk ratio operates the same way in the economy. Facing different risky choices, we choose the one with the higher reward-to-risk ratio. More accurately stated: because the outcome is uncertain and we are loss averse, we choose the level of risk we are comfortable with first, and then choose the strategy with the highest possible expected reward. The demand for this choice drives the price up, bringing the reward-to-risk ratio down into line with all other options.[35]
As humans hate the risks associated with losses, but crave the gains, the incentive for all players is to secure the gains, while shifting the risks to someone else. However, these outcomes violate the accepted moral rules governing risk-taking behavior, which is that each person bear the consequences of his/her action. Many bankers, politicians, CEOs, and public unions have gotten away with the crime of "heads we win, tails you lose" in recent years by using the taxpayer as a guarantor of risk. This is what we call "socializing the risk and privatizing the gain." It is in the interest of moral and legal justice to prevent this type of behavior and we can find support in legal statutes that defend the innocent from the crimes of the guilty.
One of the more contentious cases of socializing risk and privatizing gain has been the case of public union contracts that secure higher wages and benefits from politicians in return for political support. Public unions have insulated themselves from economic risk by assigning this risk to the taxpayers. Solutions should not focus on what these public service employees deserve or need, but whether the contracts are financially sound and fair given the uncertainty of the economic climate. Obviously, judging from the debt crises afflicting many of the states, they are not financially sound. Now it is becoming clear that those footing the bill—the taxpayers—were not satisfactorily represented at the bargaining table, and because these contracts represent binding legal commitments that states cannot abrogate through bankruptcy, resolving this unsustainable situation will invite political conflict and crisis.
The fourth and final insight flows from the reward-to-risk ratio. Since reward follows risk, or should, we can comprehend how the wealth of rewards gets distributed across society by understanding how risks are shared and borne. The distribution of risk-bearing reveals the just distribution of rewards. An interesting illustration of this is the case of Warren Buffett, considered the richest and most successful investor in America, if not the world. Buffett based his investment strategy on buying up calculated risks and then collecting the rewards for successfully managing those risks. His primary investment vehicle has always been reinsurance, so Buffett's company (Berkshire Hathaway) assumes insurance risk, gets paid for it, then reinvests the premiums in a larger portfolio of business assets on which additional profits are made.
Since all investment in the future is a form of risk-taking, by noting who bears the risks, we can be fairly confident of knowing how the rewards of economic success will be distributed. The insight that risk demands reward and reward entails risk is especially critical to policy.
Before moving on let us summarize these four insights:
1. Risk and uncertainty are ubiquitous
2. We manage the risks of uncertainty through diversification
3. Risk-bearing demands a reward
4. The distribution o
f risk has a direct relationship to the distribution of reward.
In this chapter we took the simple model of the macroeconomy introduced in Chapter One and examined how the model works in a dynamic setting over time. Since the workings of the economy are quite complex, it may help to review the ideas introduced before continuing to the next chapter on politics.
First, the macroeconomy needs to find a balance among the various activities that make up its whole: consumption, saving, investment and production. Markets are important tools that facilitate this balancing process. Nevertheless, for a variety of reasons markets can and do fail. The challenge then is to use our knowledge to get the economy back on track.
We must understand the functioning of the capital markets and how they impact the real economy, either by helping it expand or by destabilizing it with recurring financial crises. This ability is mostly due to the unique nature of financial assets as compared to other goods or service markets. The value of capital is highly vulnerable to subjective judgments of the future, falling with uncertainty and rising with confidence.
Sustainable economic growth results from the efficient allocation of capital and labor employed in production. A major complication is combining labor with capital so that the economy fully utilizes the supply of labor. Unemployment has become an important political, as well as economic issue.
Unfortunately, there is no firm consensus on which policies can best return the economy to an equilibrium growth path, so there is much disagreement between different schools of thought. There are also problems with how we measure economic performance as statistics like GDP, inflation and unemployment have been manipulated.
Merely increasing production and economic growth is not a panacea for all our economic ills. The problem is not so much producing more, but in achieving a stable and sustainable path of economic growth over time. The difficulties we face are distributional in nature and require the ability to analyze feedback processes in the economy. We also need to manage the imbalances of flows between nations that are responding to their own political demands with policies that conflict with our own.
The final complication is that we operate in an environment of risk and uncertainty. Both the reality and the perception of this environment have important consequences for the design of various economic policies and their successful outcomes.
In the next chapter we will examine how the democratic political process in its various dimensions—including electoral politics, parties, voters and the media—helps shape the policymaking arena.
Chapter Three
The Politics of Policy
Understanding the political process is essential to comprehending the macroeconomy and the real world environment in which policy is enacted. Dysfunctional politics not only lead to the wrong policies, but also inhibit the political will to make policy changes or reforms before problems lead to crises. As with economics, the critical issues in politics revolve around change and the adaptation to change. In fact, we'll find that the electoral and governing structures of American politics can impede pre-emptive change and that radical but necessary policy reforms are inevitably crisis-driven. Nevertheless, we should recognize that resistance to change is often the trade-off for a measure of political stability.
American politics has become cranky and cantankerous in recent years. Perhaps it started with the Johnson presidency and the divisions of the Vietnam War that shaped a generation. Our divisiveness was amplified by Nixon's transgressions and became hardened during the Reagan-Bush-Clinton eras. Partisan polarization finally began to rule the day when the 2000 election was decided by the Supreme Court in favor of George W. Bush. This caused a large proportion of the voting public to question the legitimacy of the presidency. The war in Iraq did nothing to dampen our differences. Despite all the hopes and promises, the Obama era has failed to bridge this divide and the administration's first two years have probably aggravated our political divisions. Hence we now have the Tea Party, a grassroots movement that demands fealty from both parties, and the recent historic repudiation of a president who rode to victory on a tide of good will. What do we make of all this? Unfortunately, our media outlets have largely joined the fray and politicized their reporting of the facts, leading to widespread distrust of politically-charged information. While democracy does not depend on us all being well-informed, it is certainly hampered by most of us being misinformed.
3.1 Democracy and the Two-Party System
One rudimentary problem that hinders our political discussions is that many of us have an unclear idea on what democracy is and how our particular American form of democracy works. The word democracy comes from Greek and means "rule of the people." That idea has been transformed in various ways into a political form of government where governing power is derived from the people by consensus, by direct referendum, or by means of elected representatives of the people. The U.S. chose this last means of divining the will of the people through representative democracy. We should note here that the formal definition of democracy does not specify "one person, one vote" or "majority rule." These terms are characteristic of voting rules or how we arrive at a social choice, but they are often confused with the principles of democratic "rule of the people." Ours is a representative democracy, or democratic republic, constrained by a formal written constitution enumerating state and federal powers, individual rights, and establishing the checks and balances of the three branches of government.
Arguments claiming how the U.S. Senate or Electoral College are “undemocratic,” merely because they are not based on majority rule, are confused or misstated. The Senate is one of the three branches of balanced government and the Electoral College is an institution that helps determine how we select a president through election rules. As parts of our governing system, neither violate the idea or spirit of democracy. To clear up this confusion this we need to separate the electoral system as a way to ‘determine the will’ of the people, from the process of ‘governing’ a free people. The former is the voting method by which we the citizenry make social choices; the second is the institutional structure of enacting and executing those choices. In other words, we need to distinguish between voting and governing.
There are many different voting systems we can apply to determine the public will. There is rule of the simple majority, the supermajority, plurality, proportional representation, instant runoff, weighted or cumulative voting, among others. This is not the place to discuss these varying methods, but the main point is that each of these methods biases different outcomes and these biases impose trade-offs. Unfortunately, there is no God-given, perfect method to enumerate and aggregate all the individual preferences of the mass of voters to come up with a single perfect social choice.[36] Voting “rules” are not a fixed principle of democracy, they are merely various social choice mechanisms where we must choose between competing visions. The democratic principle is the “right” to participate in that choice through universal suffrage. Thus, when we compare voting methods we must decide first what the objective is (Make everybody happy? Make everybody free? Make everybody equal?), and then discover how different methods weight these objectives. Again, there is no perfect solution and I will constrain this discussion to the pros and cons of the system we have chosen in the United States.
The U.S. voting system for state and federal offices is based on the plurality rule, where the candidate that gets the most votes wins. As we also have single-member electoral districts we refer to our method as single-member district plurality (SMDP). This method favors a two-party system since the candidate that gets closest to or beyond the 50% threshold will be the winner. However, plurality voting also means that with three or more candidates, the winning candidate may win with a minority of the total votes cast. For example, if candidates A, B, & C respectively win 30%-30%-40% of the vote, then candidate C wins with 40% of the total. So 60% of the polity is unsatisfied with the result. But candidates A & B could have formed a party coalition and won
with 60% of the vote. Party organizations and voters realize this and strategize to capture 50% or more of the vote. This is why third party movements in American politics are rarely successful over time. The third party either displaces or is absorbed by one of the two major parties, or withers away from lack of support. Our SMDP electoral system is deliberate and is the reason we have a two-party system in American politics.
Is this a bad thing or a good thing? Many Americans argue that we should have proportional representation (PR) and multiple member districts where all voting preferences receive representation in proportion to their voting support. So, if a party gets 20% of the vote they get one-fifth of the seats representing that constituent district. But what would be the likely result? Would we have better democracy? Certainly we would have something different. A two-party system forces people to come to the center of compromise in order to win elections. This forces voters to prioritize their preferences and find common political goals. A multiparty system with PR allows different groups to maintain their preferences and refuse compromise, yet still maintain influence in government. In Europe we see this with many different parties with incompatible political agendas. Their governing coalitions include a garden variety of Greens, Socialists, Liberals, Conservative, Social Democrats, even Communists. The main difference is that the American system forces compromise with the penalty of exclusion for uncompromising positions, while the European system allows wider inclusion with the penalty of unstable governing coalitions and inconsistent policies. So, are Europeans happier? Better governed? Richer or more equal? More politically stable? The objectives and priorities of governing—freedom, happiness, equality, inclusion, stability—shape the answers to these questions.
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