Martha A. Starr

More from Consequences of Economic Downturn on why economists missed the systemic risks that were accumulating in plain view before the financial crisis …

Bob Prasch of Middlebury College, points out how standard economic theories of the relationship between risk and return contributed to "blind spots" in economists’ judgments.

A core tenet of financial economics is that above-average returns cannot be had from safe investments; if you want to earn above-average returns, you have to invest in risky assets, which ought to pay you a premium to compensate for the uncertainty in your expected earnings. This leads to the kind of reasoning that got former Fed Chairman Alan Greenspan into trouble: He assumed that financial-market participants would not have been investing in new financial products (like securities backed by subprime mortgages), unless they judged the risks they were taking to be reasonably small, relative to the returns they could expect to earn. Thus, if all those shrewd, smart investors aiming to maximize their risk-adjusted returns saw no reason to worry about the riskiness of subprime mortgages, neither should he.

Trouble is: as Prasch argues, risk and return are not actually very closely linked in contemporary U.S. capitalism, especially for large businesses and financial institutions. A variety of laws, practices, policies, and institutions enable the wealthy and powerful to shift downside risks off themselves and onto others -- especially the unsuspecting taxpayer. Important here is the concept of ‘limited liability’, which keeps corporate shareholders and executives from having to bear the full costs of negative business outcomes. Limited liability is intended to promote socially-beneficial risk-taking, because people could be reluctant to invest in new businesses if they could be forced to sell their homes and liquidate their life savings to cover the business’s losses. But this creates a screen behind which people can squirrel returns while they are accumulating, and they don’t have to fork them back over if their bets eventually go bad. Thus, if a bank, or hedge fund, or insurance company becomes insolvent, its creditors can demand that its assets be sold to pay down its liabilities -- but except in cases of gross negligence or illegal activity, any wealth accumulated by the firm’s principals as a result of their past bad actions (e.g., outsized bonuses, realized capital gains) can remain safely in their bank accounts.

So who ends up holding the bag? In the case of the 2008 financial crisis, the federal government stepped in and "managed" the giant losses that eventually showed up on investors’ books, on the grounds that they had to in order to keep the financial system afloat. Financial executives could hang on to the outsized bonuses they earned during the boom years, no problem. Instead, the financial bailout shifted the downside risks onto average taxpayers, who had not agreed to take them on and had not benefited from the outsized gains; on the contrary, they also disproportionately bore the costs of the downturn, via lost jobs, homes, home equity, and retirement savings. (Stay tuned for future posts on this). To be sure, banking economists had warned for years of the incentive problems of "moral hazard" and "too big to fail." What Bob Prasch points out is that these are just manifestations of a broader problem of “divorce of risk and return” that runs rampant through American capitalism, whereby the "big guys" earn the returns and use their privileged command of access to power to get the "little guys" bear the risks.