Changing the rules of the game

The financial crisis is commonly blamed on excessive risk taking in the financial sector. One way to explain this is to refer to some irrational greed among banker. Economists tend to prefer to view bankers the same way they view all individuals, as an on average rational bunch responding to incentives. One explanation for the excessive risk taking that eventually lead to the financial crisis is that the rules of the game were gradually changed in such a way that utility maximizing individuals and profit maximizing firms developed an increasing taste for risk. When I say the rules were changed I mean that actors in the financial market became convinced that if their risky investments failed it was likely they wouldn’t have to bear the costs of those failures. Through precedent government had made it clear that they would not allow the key players in the financial market to fail.

So when an investor lends his money to a financial institution which then in turn invests this money in something risky, like some sort of mortgaged backed security, the original investor can be fairly certain that even if this mortgage backed security turns out to be worthless and the financial institution is left insolvent, the government will step in to save the day, ensuring that the money he lent out is paid back. This means that when he lends money to a financial institution to play with, this is a very safe investment no matter what type of risky things is then done with is money. The financial institution, be it a bank, an insurance company or whatever can then borrow very cheaply to finance risky activities investors otherwise would have shrugged away from.

Oftentimes a government rescue of a financial institution is accompanied by some sort of heavy penalty paid by the stock holders. This is assumed to prevent the rescue from setting a bad precedent and thereby encouraging increased risk taking. But it is forgotten that the banks creditors are left with their loans fully secured, without any penalty paid for their poor choice of investment. The stockholders might actually prefer the financial institution to behave in a risky manner, for without risk there is no reward, even if a failure would wipe out the value of their stocks. Since their stocks in this particular institution make up only a part of their portfolio such an event would be a catastrophe, they might even believe themselves able to balance out this risk by including some other stocks in their portfolio. It is up to the credit market to restrain the financial institution, for if it engages in a risky behavior this drives up the probability of default and also the interest rates normally demanded by the creditors. But when government in effect ensures the safety of these loans, the restraint normally placed on the financial sector disappears. Excessive risks become the norm and we eventually end up with a financial crisis.  

Political structures and crisis

The most immediate threats facing the world economy are two events with the clever nicknames 'fiscal cliff' and 'Grexit'. One involves the combined scheduled spending cuts and tax increases in America and the other the effects of a Greek default on Europe. In both cases these pose such a threat because of the dysfunctional political systems of the European Union and the United States. In America the politicians could stop this scheduled disaster by compromising and simply acting in a responsible manner. On the other side of the Atlantic the European leaders could similarly set up adequate defenses to deal with the Greek exit. With their insistence to wait until the last minute to act they are creating massive uncertainty in markets around the globe.

I would argue that it is partly the result of the political structures of these two political unions and that a centralized all powerful parliament as found in Britain or Sweden would likely not have placed the world economy in such an hazardous situation. In order to protect the conditional independence of the American states and European nations, great restraint has been placed on all centralized authority. By requiring the consent of both chambers of the legislature and the support of an independent executive as well as voting procedures requiring qualified majority approval, not to mention federal and EU actions being effectively constrained by an American constitution and European treaties. Making it very hard to take controversial decisions. When it comes to protecting the individual from intrusive new rules decided on in a far away capital this structure might serve a purpose. But when painful decisions are needed to prevent an expected economic disaster such a political structure is evidentially unable to cope, at least not in till disaster appears inevitable at which point some barely satisfactory half-measure is passed.

It is almost paradoxical how countries who group together in order to increase their economic wellbeing will, in order to persevere their political sovereignty tend to adopt a political system which will be ill-suited for adapting the policies necessary economic prosperity.

The limits of monetary magic

The power which comes from control over the money supply is immense. If the European Central Bank wanted to put an end to the Europe's economic turmoil they could simply announce the interest rates they feel are appropriate for government debt and make it clear that they will if necessary go on a shopping spree to ensure bond yields match their targets.

Putting the whole concept of moral hazard aside for a moment, there is a more fundamental reason why this is not done. While the central banker has near limitless control over demand in the economy he is incapable of generating any wealth on his own. His printing press allows him to print as many euros as is needed, but any one of those bills has no inherent value, following the inescapable laws of economics the value of every individual unit will decrease as supply increases. So the tranquility brought about by central bank action will have to be payed for in inflation.

That said, a rise in inflation might be preferable to the pain of recession. But such action will bring benefits primarily to the profligate while the discomforts of inflation will be showered on all in the monetary union. This will set a precedent that rewards those unwilling to balance their budgets and punishes those who pursue a sound economic policy. A recipe for future disaster.

Are democracies inherently fiscally irresponsible?

Anti-democratic forces around the world lead by a rising China have been quick to point to the European debt crisis as the inevitable result of parliamentary democracy. The argument is that your average voter, unable to understand the complexities of fiscal policy will inevitably vote for candidates supporting low taxes and high public spending. Looking at much of the industrialized world this appears to be true. Yet there are exceptions. The Swedish electorate appears to have learned from the Scandinavian crisis of the 1990's, since then consistently supporting parties committed to balanced budgets. Resulting in such absurd behavior as the government insisting on running a budget surplus during the worst period of the Financial Crisis of 2008 in order to avoid any charges of fiscal recklessness.

It might be that it takes a debt crisis like the one Sweden experienced in the early 90's and much of the rest of Europe is currently struggling with for the electorate to learn the importance of fiscal prudence.

Maybe more worryingly seeing the latest election results in Greece and to a lesser degree France one can question the willingness of the electorate to support the painful measures necessary to combat the crisis and restore fiscal health. It is no coincidence that it has been left to unelected technocrats to implement necessary but unpopular reforms in both Greece and Italy.

Should we fear President Hollande?

France got a new President and he is a socialist. Last time this happened was with Francois Mitterrand and he almost wrecked the French economy. Today Europe is in such a fragile state it is not just France that is in the danger zone if this President proves to be another Mitterrand.

How dangerous is he to the European Economy? Let’s look at the market, that’s what they are best at, evaluating risk. First we should note that Hollande has been the likely next president for a long time, so the effect we will see today will be that of a ‘very probable thing’ turning in to a ‘sure thing’. Still the effect has been clear, the Euro is down the stock markets around Europe are down even more, reflecting their expectations of this President being bad news for the European economy.

More worryingly bond yields in the European periphery are up, meaning the election results have made it more costly for them to borrow. Since high yields are the main reason for Europe’s current debt crisis this is indeed worrisome.

The thing that got the markets so worried is Francois Hollande’s promise to shift Europe away from austerity to growth. This is something I can partly agree with, Europe needs to do a lot more to encourage growth and some better off countries like Germany are too focused on austerity. The problem is that when I talk of encouraging growth, I mean liberalization, deregulation and privatization of the European economies, as productivity rises this should also boost growth. Given Mr. Hollande’s solid left wing credential I would guess that this is not what he means when he talks of promoting growth, he means increased government spending. More spending means larger deficits which in turn means higher bond yields and if bond yields rise high enough countries can’t pay for their own debt and we have a debt crisis.  

The economic argument against tax founding for the arts

The question of to what degree the arts should be subsidized with tax founds seems to come up at regular intervals. Oftentimes after tax money has helped finance some especially controversial piece of art.

My own position is heavily influenced by economic theory. If the cost both in terms of money and labour put in to some artistic creation is lesser than the pleasure it generates for its audience, it's a worthy endeavor. If on the other hand the cost necessary for the creation of said object is greater then the value its audience places on it, it is wasteful and should not come in to existence. Since the money and labour put in to its creation could be put to better use. That is basically my criteria for separating 'good' art from 'bad' art, that is art that should be produced and art that should not be produced.

This is also the criteria which the marketplace uses when judging products. An artist who is able to attract an audience large enough to cover his expenses will be able to stay in the profession while those who's creations the public is unwilling to pay for will be unable to live off their artistic talents and forced to put their labour to better use.

Once the government starts funneling money in to the creation of art this will no longer hold true. Artists who would do fit my criteria will no longer have to pass the test of the marketplace and will be able to stay in their current profession. Leading to the creation of art which costs exceed its benefits.

More troubling it will also lead to art which would fit my criteria of 'good' art not being produced, art which would have come in to existence if it wasn't for government involvement. Since people have a limited apatite for art, all artists are de facto competitors for the attention of the public. Tax subsidies will enable government favored art to be offered at a lower price or even for free. Making it very hard for unsubsidized art to compete, unless it is far superior to the government backed art. This disruption to the market mechanism will lead to artists who previously would have been able to live off their work be forced out of the profession, depriving the public of worthy art.

Democracy contra liberty

The political concepts ‘liberty’ and ‘democracy’ are usually seen as closely related, with one being necessary for the other to be possible. Yet in some cases they can appear to be in conflict with each other.

In the United States right now there is a judicial debate over the constitutionality of the Presidents health care plan. Once a contested law reaches the Supreme Court these two political principles can be seen as being in conflict. In the American system the peoples right to collectively decide on the laws that govern them is strictly limited by constitution intended to protect individual freedoms, in a sense a highly undemocratic idea, one that prioritizes the individual over the community.

If democracy is thought of as a system to control the power of the state by making it subject to the will of the people, in order to protect the individual citizen. Then democracy is a mean in order to further individual liberty. Then it also makes sense to place limits on the ability of the collective citizenry to act in a manner contradictory to aim of democracy, which would be individual liberty.

If democracy instead is thought of as an end in of itself, as a superior system to regulate human activity, then placing limits on it would be folly. It would constrain the ability of the people to create the best possible conditions under which to live their lives.

The current American system would seem to have been crafted with a view of democracy more in line with the first of these two perspectives. My own country of Sweden would seem to have a democracy shaped by a view of democracy closer to the second of these perspectives, where the citizenry is trusted to a greater extent not to use the political process to strip themselves of their freedom and given more room to violate the perceived rights of the individual if the benefits to the group is considered great enough. The source of these differing views on democracy can be debated but the Sweden being a much more homogeneous society likely played a part.