Home > finance > The basic unit is risk

The basic unit is risk

June 27, 2012

Today I’m going to gush over two excellent blog posts I read recently written over at Interfluidity. But first I’m going to state a pet theory of mine about what units we talk in.

In a mathematical sense, units make no difference. If I give you measurements in inches rather than feet, all I’m doing is multiplying by 12. If I say something in French rather than German, all I need is a translation and we’re talking about equivalent information.

But in a psychological sense, a choice of units can make an enormous different. Things sound bigger in inches, and sometimes you barely understand French and can make bad guesses.

I’d argue that speaking in terms of wealth is a mistake. We should instead speak in terms of risk. It’s a different unit, and it’s harder to quantify, but I think risk is what we actually care about. I claim it’s more basic than money.

For example, why are we afraid of not having money? It’s because we run the risk of not having resources to eat, sleep, or get medicine or treatment when we’re sick. If we didn’t have fears about this stuff then people would have a very different relationship to money. The underlying issue is the risk, not the money.

Financial markets putatively push around money, but I’d argue that why they exist and how they actually function is as a way to spread around risk. That’s why the futures market was developed, for farmers to have less risk, and that’s why the credit default swap market was created, to put a price on risk and sell it to people who think they can handle it.

It also kind of explains, to me at least, the weirdness of super rich people- people who have more money than they can ever use. Why do they continue to collect money so aggressively when they already have so much? My guess is that they are confused about their units- they think all their problems can be solved by money, but their remaining actual problems are problems of risk that can’t be controlled by money. Things like the fact that we all get old and die. Things like that people don’t like you if you’re an asshole or that your wife may leave you. These are risks that most people never get to the point of trying to solve through money, because they’re still stuck in a different part of reality where inflation could screw their retirement plans. But for super rich weirdos, we have the Singularity University where you get to learn how to transcend humanity and live forever.

I’m not making a deep statement here. I’m just suggesting that, next time you hear of a plan by politicians or regulators or Wall Street bankers, think not about where the money is flowing but where the risk is flowing.

A perfect example is when you hear bankers say they “paid back all the bailout”; perhaps, but note that the risk went to the taxpayers and is firmly fixed here with us. We haven’t given the risk back to the banks, and there doesn’t seem to be a plan afoot to do so.

Which gets me to Interfluidity’s first plan, namely to have the government protect up to $200,000 of an individual’s savings from inflation.

Now, on the face of it, this plan is not all that protective of the 99%, because it’s definitely benefiting people who have savings, where we know that the lowest 25% or so of the population is in net debt. Only people with savings to protect can actually benefit.

But if you think about it more, it is good for people like my parents, whose retirement from a state school does not rise with inflation, or more generally for people who have a fixed savings put aside for retirement. And it isn’t at all good for very rich people, who would see a benefit only on a small percentage of their savings (assuming it is possible, as Interfludity says it is, to outlaw the bundling of these inflation-protected accounts like some people now bundle life insurance policies).

Most economic policies in this country are made to benefit rich people, and are defended by saying we need to protect middle-class people nearing retirement with a modest nest-egg. As Interfluidity said, those middle guys are used as “human shields”. Very few policies go into to the weeks sufficiently to figure out how to protect that group without having outsized benefits at the top.

Said in terms of risk, this plan is pushing inflation risk to people who can handle it, and removing it from people who are extremely vulnerable to it.

Which brings me to the second post I want to rave about, namely this one in which Interfluidity dissects the lack of political will in the face of the current depression. From the post:

We are in a depression, but not because we don’t know how to remedy the problem. We are in a depression because it is our revealed preference, as a polity, not to remedy the problem. We are choosing continued depression because we prefer it to the alternatives.

The reason? Because no matter how much someone might say that we care about the middle class, the truth is we are protecting rich people from the risk of getting poor. We have, as he says, a population with individual power roughly weighted in proportion to their wealth (or, to be consistent with my theme, inversely proportional to their risk), and when you take a vote with those weightings, we get a “weighted consensus view,” manifested among the macroeconomists in charge of this stuff, that we should avoid inflation at all costs (ironic that the people with the least risk are also the people with the most influence).

In order to remedy this situation, we’d need to implement something like the inflation-protected bank accounts up to $200,000 for the individual. Then the weighted consensus may change – we might instead actually pull for a policy that would have some risk for inflation and would also possible create jobs.

But of course, in order to implement such a policy, we’d need to have the political will to change the risk profile, which goes back to the weighted consensus thing. Keeping in mind that this policy would push the risk to rich people, I’m guessing they wouldn’t vote for it.

On the other hand, smallish savers would. So it’s not a mathematical impossibility, because there may be enough people in favor of the inflation-protection plan to make it happen, and then the second question, of how to get us out of the current depression, would be easier to address. I’m definitely in favor of trying.

Categories: finance
  1. None
    June 27, 2012 at 8:01 am

    We need less government intervention, not more. The inflation is a problem in the first place because the governments are pumping borrowed money into the system for their pet beneficiary projects that ensure they get elected by those getting the payouts. Now you suggest they also guarantee against the inflation they are creating, so that when a scenario kicks in where under extreme inflation (with noone having taken any measures because they all have the guarantees) large numbers of payouts are needed, the government has to magically create even more money, and pump that into an economy suffering from high inflation. Real smart move.

    PS people with net debt can still have huge savings

    PPS your point about the banks not taking back “the risk” after having paid the bailouts, I simply dont understand. What risk ? There was a temporary shortage of credit, making some banks technically insolvent, the govenment just lent money until credit freed up. Should the government have done that in the first place ? No. Did the government take on any risk doing that ? No.

    • Joe Junior
      June 27, 2012 at 8:08 pm

      Do you know what was happening in Japan’s economy in the last two decades? Zero interest rate, expansionary fiscal policy. Result: deflation. The problem the US facing now is not inflation, the problem is demand is way lower than supply. Targeting a relatively high inflation would encourage businesses and people to spend. Because (nominal) interest rate can’t go below zero, setting a higher target of inflation will bring the (expected) real interest rate to negative and it will give a push to the demand side.

      Arguing inflation is bad in the current situation is like suggesting a seriously sick man to stop antibiotic because virus will evolve stronger and it is real bad in the long run. It sounds wise but god bless the poor man.

      You also need to understand if “governments are pumping borrowed money into the system” then it’s not inflation. Inflation is caused by “printing” more money. If the government borrow money and spend it then it’s a re-distribution of resources. It has nothing to do with inflation.

      “PS people with net debt can still have huge savings”: wise but what is your point?

      “PPS your point about the banks not taking back “the risk” after having paid the bailouts, I simply dont understand. What risk ? “: It’s pretty clear, it’s the risk that banks can get bailout in the first place and taxpayers (ordinary people) pay the bill and are suffering from the bad economy. Yea they pay back the money but what a mess of the economy after the crisis? What about the next time bad thing happen again? In good time they leverage and make huge sum of money, in bad time they just ask for the government to give them a hand? Head they win and tail you lose? Is this risk resolved?

      • Jim Plante
        August 17, 2012 at 5:32 am

        Your understanding of inflation is flawed. Inflation is an increase in the supply of money or currency in circulation versus goods and services. You can have inflation in two ways: Increase the money supply (whether through printing or lending into circulation); or destruction of goods and services (Katrina? 9-11? Floods in the midwest?)

  2. sma045
    June 27, 2012 at 4:19 pm

    Money isn’t everything. There is a real world out there. In that real world, if we tried to have the sort of growth that Krugman and others want, then we’d need to pump more oil worldwide than is currently physically possible. We are growing as fast as the rate of infrastructure transition away from oil (to natural gas, electricity, etc) allows.

    The real issue is how to share the pain fairly, but we can’t get to that discussion while we assume that its all about money and reality is irrelevant. I do support the need for inflation. However the trick is to print money and send it to the voters directly, not buy bonds.

    How much inflation do we need? Our main experience since WWII is that economies run well with about 3% growth and 2% inflation. This means about 5% growth in the nominal economy (the size of the economy in dollars, without taking into account the decline in the value of the dollar). It seems likely that this applies whatever the growth rate. If the real growth rate is 10% then a 5% deflation rate won’t cause any problem. On the other side of the ledger, if the real economy is declining at 2% for some reason, then you need 7% inflation to keep the wheels of commerce moving.

  3. albrt
    July 1, 2012 at 9:07 pm

    Getting paid with money and then using it to buy what you need immediately has a very minimal risk factor most of the time. Money only translates to risk when you are trying to use it as a store of value, instead of as a medium of exchange.

    It turns out that trying to store up value and use it much later during a long period of non-productivity is a really difficult problem, especially when a lot of people do it at the same time. Their stored value has a very strong tendency to become less valuable, both through pricing mechanisms and through the institutionalization of means for people (especially bankers) to divert the value.

    During relatively stable economic times, economists seem to lose track of this problem and mainly think about the exchange systems in the economy. I think this is another side of Minsky’s instability cycles.

  4. FogOfWar
    July 2, 2012 at 9:51 pm

    Very interesting.

    Friendly amendment: what if risk is “a basic unit”. I don’t think risk alone can be the only unit….

    FoW

  5. Andy Rollins
    August 5, 2012 at 1:48 pm

    Seems like Maslow’s Hierarchy of Needs needs to be part of the discussion, if we’re moving to risk. It’s a great point.

  6. H.Z.
    August 9, 2012 at 3:54 pm

    Anyone can buy TIPS, which still pay a positive real interest at the very long end. You used to be able to buy I-Bonds for $30000 per person per year. Now you are still allowed to buy $10000 per year. Very little withdrawal penalty (none after 5 years). How many people save that much each year? I don’t think you really hit the problem yet.
    Wealth is not just about money, it is about control. It is only for the marginally wealthy passive investors that it is more about insurance.

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