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The great risk shift

December 3rd, 2008

I’ve spent the last couple of days at a workshop sponsored by the Academy of the Social Sciences in Australia on shifting allocations of risk. Most of the papers were well underway when the collapse of global financial markets implied the need for a radical revision of thinking. So a lot of discussion was prefaced with “at least until the onset of the crisis, this trend was ….” Here’s my paper.

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  1. Alanna
    December 4th, 2008 at 07:17 | #1

    John – you note
    As regards taxation, there has been a huge reduction in the tax payable
    by high income earners in recent decades. This reduction has been justified by
    the claim that only by providing incentives to this group can strong economic
    growth be maintained.

    I could not agree more and I see that as a major concern. What was once (in the 1950s and 1960s) recorded as managers salaries on financial statements ie income on which income tax was payable has been shifted by all sorts of creative mechanisms to payments of capital eg shares, options etc I would argue specifically for the main purpose of reducing tax on executive and managemnt salaries despite what has been touted as incentive structures (yeah right).

    It isnt fair on the majority who remained compelled to shoulder their share of the tax burden. Where is the ATO on this? Asleep?

    Alanna

  2. Marginal Notes
    December 4th, 2008 at 09:33 | #2

    A striking feature of the Costello ‘enforcing of choice’ in superannuation was that the majority (e.g., in Unisuper) elected to remain in the defined benefit division, reluctant to take on the additional risk, even though at the time it seemed small relative to what has eventuated. Not only has this been an issue of shifting risk onto employees as a group, but now there are sharp differences in risk-bearing among employees – those whose super is now tied to stock values are helping funds maintain their capacity to meet defined benefit obligations. What is your reading of the risk facing super funds and what is the likely government response if the critical ratios continue to fall?

  3. tim watson
    December 4th, 2008 at 09:38 | #3

    John, I wonder whether you see a role for mutualism/distributism in the financial sector as a third way to the free market/nationalism duality that seems to be dominating the current debate?

    What would be the economic considerations mitigating against such an approach?

    It seems to me that co-operative financial and other business entities may provide a more sustainable and stakeholder focused framework for risk management in future years.

    Is mutualism an idea whose time has come (Or come again some may say)?

  4. December 4th, 2008 at 11:37 | #4

    Tim Watson, hie thee to Kevin Carson’s blog (he also links to distributist sites).

  5. observa
    December 4th, 2008 at 11:52 | #5

    We have a situation somewhat analagous to the AFL GF where there is always more desiring bums than accomodating seats. Wisely everyone listens to the Observa and his EMH and decides to auction the seats. Unfortunately the AFL in its superior wisdom has issued more tickets than seats(after all not every ticketholder goes and who cares if Collingwood are playing) and the inevitable occurs on the Big Day. JQ astutely concludes that next year things will be different and the Dept of GF Tickets will do the distributing. Meanwhile the AFL goes back to balancing its books for the year and mulling over dire threats from soccer.

  6. tim watson
    December 4th, 2008 at 12:51 | #6

    Thankyou Mr Lawrence- Kevin Carson is probably a bit more at the bomb-throwing-anarchist end of what I’m alluding to!

    I’m thinking more along Mondragon/Race Matthews/Fabian lines.

    But thanks again for some amusing reading.

  7. Jim Birch
    December 4th, 2008 at 13:11 | #7

    John

    FYI, there’s a typo in that pdf: look for “The unsustainability” [of this is obvious, I guess.]

  8. Michael of Summer Hill
    December 4th, 2008 at 13:52 | #8

    John, people don’t mind socialising risk so long as it benefits society, but there are limits. And if things get worse then governments will fall back on proven and trusted economic models.

  9. December 4th, 2008 at 14:05 | #9

    “[B]omb-throwing-anarchist”? That sounds like guilt by association to me.

  10. tim watson
    December 4th, 2008 at 14:32 | #10

    You’re right, I’m not greatly familiar with Mr Carson’s ideas. So i apologise for the vulgar generalisation.

    But our point of divergence could be summarised as follows:

    Without wanting to go all Anthony Giddens, I think there is a place for mutuals as a third way alternative to the private/public ownership debate as it relates to risk management.

    From what little I know, Kevin Carson advocates mutuals as a replacement for “the system” in it’s entirety.

  11. December 4th, 2008 at 15:45 | #11

    Tim Watson, here’s a distributist blog for you.

    As I read him, you are subtly mistaken about Kevin Carson. He strongly suspects that mutuals could replace “the system” in its entirety, and that something will probably have to as “the system” actually is broken – even if that might not show from certain perspectives and/or values. However, he only advocates “building the new [mutualist and anarchist arrangements] within the shell of the old”, so as to have it ready at system level and as a fallback for individuals who can tap into the new, as, when and if necessary. That “building” includes researching, educating, and so on.

  12. tim watson
    December 4th, 2008 at 16:12 | #12

    Thanks for the links, I will have to read more :D

  13. December 4th, 2008 at 16:51 | #13

    Thanks for the link, PML.

    Tim, I’m mostly peaceful, as PML says, and prefer the peaceful construction of an alternative social order within the existing one. But I probably wouldn’t cry if the bleeding heads of some billionaires and Fortune 500 CEOs wound up on pikes.

  14. haiku
    December 4th, 2008 at 17:27 | #14

    JQ – page 14, “But previous crisis since the 1970s, such as the stock market crash of 1987 have also exhibited evidence of financial markets.” Think there might be “the failure of” or a “the instability of” missing.

    Also – page 19, “The unsustainability …”?

  15. Kien
    December 4th, 2008 at 19:54 | #15

    Discussions on the causes of the current financial crises seem to divide into two broad categories: (A) one attributes cause to the trade imbalance and “blames” developing countries for intervening in currency markets to keep the US dollar high; (B) another attributes cause to excessive leverage and “blames” the US (and perhaps other developed countries) for failing to regulate financial markets.

    Thus the financial crises is seems to have been caused by both excessive government intervention (in currency markets) and inadequate government intervention (in financial markets).

    Perhaps the lesson is not whether there is too much regulation or too little regulation per se. Rather, the lesson seems to be that a healthy capitalist economy needs to be supported by appropriate regulation.

    China and most developing countries remain committed to a realising a market based economy as a long term objective, but are taking their time to work out an appropriate regulatory framework in support of that long term objective. The US and other developed countries have also not abandoned this objective, but seem to be working towards an appropriate regulatory framework from an opposite direction.

  16. observa
    December 4th, 2008 at 22:31 | #16

    “Discussions on the causes of the current financial crises seem to divide into two broad categories:…”
    And that’s THE problem now according to Austrian economics. Basically both camps have a vested interest in ignoring the complete failure to control money supply growth and just what it really means for us all now. Take the Australian example where M1 grew 163% between March 96 and Dec last year until the Reserve started getting nervous about inflation and turned off the spigot with such scintillating timing. What they should have recognised was the US example whereby employment in the goods producing sector was falling as overall employments was rising. In fact the former has fallen for 24 consecutive months to date, which Austrian analysis predicts is precisely what will happen as the effects of credit expansion finally drive many industries at the higher stages of production to the wall. That is if they haven’t already been seduced themselves like the GMs and GEs by the easy money euphoria and its moral hazard.

    To admit Austrian economics was right means a past Coalition Govt has to admit it got money supply badly wrong and its surpluses were largely illusory or soft ones, albeit they’d be the envy of many other inheriting govts nowadays. Then for Labor to admit the same, rather than blaming everything on the ‘international financial crisis’ now, means admitting they’re fairly powerless to do anything about our situation. Much better to run about looking useful, introducing more financial regulations,(as if we never had so much of it already) or our financial institutions need any further guidance with the bleeding obvious. Neither camp has any interest in the simple truth that printing money created complete moral hazard for public and private players alike which we see all about us now. How any serious analyst can even begin to talk about ‘efficiency’ in public or private marketplaces when the very medium of exchange is so corrupted is beyond Austrian comprehension. Basically we are morally ambivalent to their behavioral preferences for stealth over greed or vise versa.

  17. Nick K
    December 5th, 2008 at 09:16 | #17

    JQ says “As regards taxation, there has been a huge reduction in the tax payable by high income earners in recent decades. This reduction has been justified by the claim that only by providing incentives to this group can strong economic growth be maintained.”

    It’s true that marginal tax rates for high income earners have been reduced significantly in most developed countries over the past few decades. But there has not been a fall in the actual amount of tax paid.

    In the US the top marginal tax rate was 91% in the early 1960s, and I believe it was around 90% in the UK at some point. In Sweden I believe they reduced the top rate from 80% to 50% in the 1980s.

    The reason why many countries reduced their top marginal tax rates was simply because when rates were set at confiscatory levels, people would go to any lengths to avoid them and there was no incentive to earn that money. Governments worked out that there were limits to how progressive taxes could be, and they could raise more revenue from a slightly more realistic rate.

    This often had little to do with market-based ideology or ‘neoliberalism’. It was simply a case of pragmatic governments working out how they could pluck the goose with the minimum amount of hissing.

  18. jrbarch
    December 5th, 2008 at 11:28 | #18

    Hi John – thanks for publishing your paper on Risk Shifts; I enjoyed reading it and am a little clearer now on some of the misconceptions fundamental to the political conflict here in Aus. and abroad.

    Risk seems to be a bit like the oscillation index, sloshing between the twin poles of businesses and households, with government intervention (management?) not all that helpful overall, at either end. Unfortunately, nothing new there!

    Just an opinion, but in my view the situation can be modelled quite simply.

    All policies (in all disciplines but here we are talking economics), whether social democratic, economic rationalism or any flavour in between fall and divide on one knife edge: in one face will be mirrored human generosity, kindness and inclusiveness; and on the opposite the darkness of the lack of these qualities. Think about it!

    Squarely a human problem! Put simply, selfishness invariably brings human beings pain, conflict; and stunts their growth.

    The food supply (for people), education, health, security of living, environmental and ecological sustainability, are in one aspect economic problems, whose resolution are absolutely essential to peaceful living on our planet (otherwise security is held together by painful force). David Attenborough would tell us there is only one human species on just one small and beautiful jewel of a planet (not another one around for light years apparently), and the food supply (courtesy of nature) would be used with the greatest wisdom if it benefited us all. This is also true of education, health, security of living and environmental responsibility.

    Here is the challenge for economists I believe: the hypothesis is – can it be proven through rigorous economic modelling (the sort that the weather guys use rather than the lamebrain sort the OECD or reserve banks apparently use – proving their incapability through not even being able to predict a financial crisis of the magnitude of today’s melt down, let alone asininely predicting the global economy heading in the wrong direction) that risk is best managed through kindness.

    Too simple? It takes a while for the head to catch up with what the heart already knows! Am sure there is a cost-benefit there somewhere?

    I don’t mean charity. I mean human growth – a human being – being valued intelligently by all as of far greater worth than what is so stupidly called ‘wealth’.

    We’ve tried all the dumb stuff. Human beings who believe in themselves – the unlimited potential of the human heart where the soul of a man resides. That’s what hasn’t been tried yet!

    The human intellect has not come up with any solutions!

    Would that constitute an “effective social response”?

  19. STT
    December 5th, 2008 at 14:45 | #19

    John,

    Thanks for putting your paper up, it’s an interesting read.

    I think see a bit of a gap in your arguments about the efficient markets hypothesis. Could you help me out? On page 18 you define the ‘semi-strong’ version of the EMH as claiming that:

    ‘asset prices are at least as good as any estimate that can be made on the basis of publicly available information’

    You go on to say:

    ‘In the light of the experience of the last decade the semi-strong EMH appears indefensible’.

    The problem I have is that I can’t for the life of me think of what other methods we have for estimating the value of securities. While it is apparent that the estimates of the value of CDOs were WAY off, who could have come up with a better estimate? Presumably whoever could have done a better job is now sitting on a private island they bought with the proceeds of short selling. How do we identify these sages before the event?

    In a way, your statement that the EMH is ‘indefensible’ is really just pointing out that the EMH is a pretty lame set of words: effectively it just says ‘where the price is set by the market, the market is the best predictor of the price’. So rather than simply trashing the EMH, are you suggesting that some things should not be priced by markets? And if not by markets, how? By administrative fiat? Or are you saying that some things (e.g. opaque derivatives like CDOs, CDO^2 etc.) should not exist in the first place?

    Thanks again for the paper (makes my Friday arvo go a bit quicker).

    STT

  20. jquiggin
    December 5th, 2008 at 15:37 | #20

    STT, I had a long debate with Joseph Clark about short-selling. For a bunch of reasons, I think the rational thing to do when presented with an overpriced market is to sell down to zero, and only take short positions to the extent that your liquidity permits. It’s easy enough to point to sages who did this much.

    You make some good points about the meaning of all this.

    I’m suggesting that monetary/regulatory authorities, faced with market asset prices that look like they are bubbles, should treat them as such, rather than assuming that the market is always right. To the extent that bubbles are driven by financial innovations such as CDOs, those innovations should be constrained.

    I am also suggesting that market valuations should not be regarded as particularly useful in the evaluation of, for example, public investment projects.

  21. Alanna
    December 5th, 2008 at 22:29 | #21

    Nick you said

    “The reason why many countries reduced their top marginal tax rates was simply because when rates were set at confiscatory levels, people would go to any lengths to avoid them and there was no incentive to earn that money. Governments worked out that there were limits to how progressive taxes could be, and they could raise more revenue from a slightly more realistic rate.

    This often had little to do with market-based ideology or ‘neoliberalism’. It was simply a case of pragmatic governments working out how they could pluck the goose with the minimum amount of hissing.”

    Well I can see the sense in that Nick but the only problem I have is asking the question – was this processing of reducing the top marginal tax rate done once or done inrementally by every passing tax commissioner who had the same idea??? Because the top marginal rate has been reduced more than “slightly” since the 1960s in many countries and has it halted the coversion of what is in reality payments of income (on which income tax is payable)to payments of capital (shares, options etc). No, these income tax avoidance inventions constructed into corporate remuneration packages have exploded just like the creation of financial derivatives.

    The ATO are chasing the wrong idea and they need to work more closely with those who write the corporations legislation.

    I continue to suggest the watchdogs are either asleep or digging the wrong hole to find the bone.

  22. Nick K
    December 6th, 2008 at 12:37 | #22

    Alanna,

    “was this processing of reducing the top marginal tax rate done once or done inrementally by every passing tax commissioner who had the same idea???”

    Well, the tax commissioner does not have the power to determine the top marginal tax rate. That is dictated by legislation. But I guess the tax commissioner does have some discretion as to which taxpayers to go after, and the commissioner would advise the government on policy changes and their likely impact.

    In a lot of cases, reducing the top tax rate was not done incrementally. It was often done in short periods of time. For example, the top tax rate in Australia was reduced from 60% to 47% at once. In the US I believe it was reduced from 70% to about 28% (probably too low IMO) under Reagan.

    You may be correct in arguing that reducing the top tax rate has not eliminated a whole lot of exotic tax-minimisation planning. But I still think that ensuring the rates are not too high does have some impact in reducing the incentive for elaborate avoidance.

    In the past when top marginal rates were very high, I guess a lot of tax-minimisation strategies were relatively simply by today’s standards. Basically, either convert as much income to capital gain (a la Bottom of the Harbour), hide income, work in the cash economy. Or else simply don’t make a lot of money if the government will insist on taking most of it.

    It may be true that top tax rates have fallen substantially since the 1960s. But this was coming off ridiculously high levels (such as 90% in the UK and US). Also, consumption taxes have been increased. So the well-off aren’t paying less tax overall.

  23. observa
    December 6th, 2008 at 22:39 | #23

    “policies..fall and divide on one knife edge: in one face will be mirrored human generosity, kindness and inclusiveness; and on the opposite the darkness of the lack of these qualities. Think about it!”

    I have and rejected it as too simplistic. A world full of Mother Theresas wouldn’t work for the obvious. Tis better to give than to receive needs the implicit understanding that without having received in the first place one cannot possibly give. Perhaps that’s why we come into this world only capable of receiving. When we’ve worked out individual self interest thoroughly we can get a proper handle on the social/communal self interest bit.

    ‘in one face will be mirrored human generosity, kindness and inclusiveness; and on the opposite the darkness of the lack of these qualities.’

    Hmm..I don’t think I’d want you in my baby-sitting club but rather save you strictly for teenagers so you can work out the appropriate level of tension between individual and social self-interest;)

  24. Alanna
    December 7th, 2008 at 21:56 | #24

    Nick

    You said

    Also, consumption taxes have been increased. So the well-off aren’t paying less tax overall.

    After what I read about executive remuneration – this is the only thing I like about the GST. One thing you can count on is that the rich usually consume richly. Perhaps we should implement a marginal GST on luxury goods. The more luxurious the good, the larger the GST. The ATO should put 90% on grange, artworks and on waterfront property for a start. That would pluck a few gooses.

  25. Nick K
    December 7th, 2008 at 23:01 | #25

    Alanna, I agree, to a point that there should be higher taxes on luxury goods.

    Indeed, there is a respectable argument to be made that where some luxury items are largely status symbols, increasing their cost through higher taxes does no economic harm but merely enhances their utility as status symbols. This is probably true of things like expensive jewellery or gold or platinum credit cards.

    Personally, I agree that there should be an additional luxury tax on top of the GST on various things. The problem with luxury car taxes and the like is that they are too narrow and selective imposts. There should be a broader tax on non-essential goods and services.

    Generally speaking, shifting more taxes away from income and business profits onto consumption is good economic policy. That is because taxes on income and business profits have a negative effect on incentives for work and investment. Taxes on consumption don’t hit the supply side of the economy to the same extent.

    Alanna, so long as you don’t want to slap a luxury tax on Stella Artois or second hand BMW’s, I’ll be cool with it :-)

  26. Nick K
    December 7th, 2008 at 23:29 | #26

    As for the debate on the Efficient Markets Hypothesis, or the notion that market values of assets are the most reliable guide to underlying value available, I would say the one area at the moment where market values are most out of whack is the housing market.

    I don’t think any sensible person who doesn’t have a vested interest doubts that housing prices are seriously overvalued, and are not a reliable guide to the underlying value of housing.

    But in this case there are a couple of factors that explain it:
    - governments have distorted the market through favourable tax treatment for housing (including CGT exemption for primary residence), as well as the high costs of government charges in building new homes which put a floor under house prices
    - because many average homebuyers tend to be less knowledgeable on financial matters than those who purchase other investments, the market is less well-informed
    - housing is often more a lifestyle matter than a rational investment decision

    The tax breaks are particularly significant, in that tax minimisation often has an irrational appeal. People will often chase tax breaks even if investments turn out to be duds and lose more value than what the tax break is worth.

    This is one case where the EMH does not work. But I think it is atypical compared to other markets, because of higher government distortion and the ignorance of purchasers.

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