Gains and Losses

Gains and Losses

October 31, 1998

The allocation of capital, deciding how to invest today’s scarce surplus to achieve a better tomorrow, is among the most critical economic tasks of society. Our ancestors faced the challenge of deciding whether to plant in the fertile but potentially risky flood plain, or in the less fertile but secure uplands. The modern investor must decide whether to finance a mining project in Indonesia, or software development in Utah. Societies have experimented with many capital allocation policies, private and political, but one rule has proved dominant: wise investment decisions will only predominate if the investor experiences both the gains and losses of his decision.

Time and again politicians have sought to escape this hard fact. There are always "good" reasons to socialize risk – allowing investors to suffer would be "unfair," a contagion effect will lead people to avoid good as well as bad investments, a large failure might destabilize markets, and so on. Politicians rarely recognize that such interventions promote serious moral hazards, and wish away the fact that people become less risk averse once they are confident someone else will pay.

The critical need for the efficient use of capital was a powerful constraint in the evolution of market institutions. Societies, especially poorer ones, have little wealth and thus little scope to invest. To squander that wealth is among the most costly mistakes a society can make. Mistakes are inevitable – the floods come or do not, the new mine or plant is or is not competitive – but the threat of these pitfalls encourages responsible investor behavior. Freeing investment from this raw discipline can have great political appeal, but the resulting moral hazard will be far more costly.

This lesson should have been evident after the Savings and Loan disaster of the 1980s. Then, the government propped up a bankrupt industry through federal deposit insurance to avoid "runs" on sound banks. In so doing, they created a more severe contagion effect by encouraging "smart" investors to transfer hundreds of billions of dollars into badly managed S&Ls. Undeterred, Washington is now considering an expansion of federal flood insurance, boosting Overseas Private Investment Council (OPIC) credit, and International Monetary Fund (IMF) assistance to bankrupt nations. The US is not the only culprit; developing nations have contributed to current financial strains through political capital allocation plans, the manipulation of monetary exchange and interest rates, and their own deposit insurance programs. In the face of such pervasive political distortion, the wonder is not how capital came to be so badly invested, but how there are any prudent investments at all.

Yale’s George Priest has crystallized the problem of moral hazard in a comparison of private and political insurance. Private insurers review the risks of an investment decision (whether a new home or a new technology) and assess premiums accordingly. They then invest this income in the most productive opportunities available. This process automatically steers investments away from higher to lower risk areas. In contrast, political insurance subsidizes risky activities through taxes on productive sectors. Private investment mitigates moral hazard; political investment exacerbates it.

History clearly demonstrates that when we weaken the corrective safeguards of the market, the critical profit-and-loss feedback loops that encourage better investments over time, we end up eating our seed corn. When will we learn?