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Moral Hazard, part eight

Blog entry posted by anciendaze, Aug 7, 2011.

My goals in starting this series have been obscured by subsequent events, but one underlying theme has been strongly reinforced. Individual humans exhibit 'bounded rationality', even when pursuing narrow self-interest defined in numerical terms. If any participants in the debate in Congress intended to raise the costs of borrowing, and contract the supply of money, they were very quiet about these intentions. Such objectives fit the idea of waging 'economic warfare' against the West, best expressed by a certain recently-deceased militant. I don't claim those pushing events in this direction had any such intent, only that the outcome went beyond calculation.

Debts of sovereign nations are built into the very foundations of global systems of credit. Far from affecting only the current U.S. administration, this shock runs through all sectors of the economy in nations far removed from the ordinary run of U.S. politics. Inside this country, it will quickly ripple down to the level of loans to individuals and small businesses. Don't expect many people to be happy when this takes place.

At present the wild swings caused by money fleeing for the exits after a shout of 'fire' in a crowded market make it impossible to determine the effective rate of interest for very large, exceptionally-sound loans. Based on rates just prior to the excitement, I would guess this was around 1%. Against this background we have reliable data showing the effective rates for sovereign debt of Italy and Spain are running above 6%.

A spread of 5% due to risk of default may not sound like much to people using credit cards, but then defaults on credit card debts happen all the time. For people who trade in T-bills, differences of 0.01% are considered significant. The message of those interest rates, with spreads 500 times this minimum increment, is that the risk of huge defaults is very real.

When a functioning corporation changes hands at a price above the total price of identifiable net assets and liabilities, the difference is called 'goodwill' in accounting. Keeping it functioning is typically a good idea, as loss of customers and business partners can destroy this value. This generally intangible value can be very large in respectable present-day business.

A large part of the value of national and international economies would fall into this category, if the same principles were extended that far. In the past this part of the values on markets have been credited to "animal spirits", "irrational exuberance" and, less thrilling, "market psychology". "This Time is Different" (another title) is a phrase credited with "the most dangerous four words in economics". What people believe about financial matters has a very real effect on money.

The goal in dealing with this inescapable fact of life should not be to turn economic policy over to machines. (That way lies ruin. Example: Bernie Madoff made extensive use of machines which, conveniently, never challenged his reasoning.) Transparency and intelligibility should be essential economic goals. It is not enough to depend on identifiable experts for opinions, it must be possible for many people who make the effort to decide if a particular value is or is not reasonable. This doesn't have to be everyone, just those few who really try. When obscurity and complexity defeat this check on madness, the obvious remedy is to avoid or withdraw that particular investment until clarity is restored. Pulling down the pillars of the entire edifice on top of one's self goes beyond reason.

Long ago, in circumstances that would take us far outside this subject, I developed a special faith in checks on what geologists call "ground truth". (It might have been because my life depended on some numbers representing true values.) I quickly learned that nothing is foolproof, because fools are far more inventive than most of us acknowledge. Intellectual and temporal limitations caused me to skip a lot of plodding step-by-step reasoning, and insist on 'end-to-end checks'. This was especially true in those cases where people vociferously insisted no check was needed. Bringing in others supporting these opinions reinforced my determination. (You can tell I am just not all that easy to get along with.)

As a mundane illustration, I just finished a dispute with auto mechanics in which they told me the cooling system of my car was working fine, because they had checked each component. I took the vehicle out with lights and air conditioning on, in start-and-stop rush-hour traffic, and managed to return it just as it boiled over. Further argument was unnecessary.

You really don't want to push airplanes to the breaking point, but checking that what goes in and comes out of large subsystems matches expectations can save a great deal of argument about details. Even computer networks, (which are unlikely to fall from the sky or explode,) benefit from attempts to connect local and global (overall) behavior of systems. Anyone can be overwhelmed with detail. No one has the kind of prescience shown by heroes in action movies. (Generally, I class movies less as fictions than fantasies.)

What I was trying to emphasize concerning finance was the general lack of such comparisons, of local and global behavior, at present. Indeed, we have allowed incentives to become so severely distorted people can benefit personally from the destruction of organizations and institutions they allegedly control for the benefit of others. We have allowed complexity to reach the point major parts of financial institutions have become incomprehensible to those in charge.

*insert paragraphs from comment below here*

Pushing this thesis into the dangerous territory of politics and healthcare is likely to provoke outrage. (Forgive me if I step on your toes through ignorance.) Part of what I want to convey is a concept of scale.

We all know that funding for research on ME/CFS is a minuscule part of all biomedical research.

The explicit deficits resulting from the bailout necessary to prevent an immediate collapse of the financial world in 2008/2009 dwarf total annual federal expenditures for biomedical research. (The costs of implicit guarantees made at the same time are still off the books.)

Even within the explicit accounting for the costs of the wars in Iraq and Afghanistan the deficits due to these wars dwarf the explicit costs of the bailout. Again, there may be costs associated with political guarantees which will only become apparent to later generations.

The general term for future federal expenses not on the books is "unfunded liabilities". Exactly how large these may be is a highly contentious subject. I don't pretend to have solid answers here, but I can note that the Social Security system lies in this category.

Disputes about funding of Social Security are even more explosive than most arguments about government financing. Again, I'm going to sidestep numerical arguments, except to say most observers agree that predictable future expenditures will be larger than current explicit federal debt. Exactly how this is paid for is not my present concern.

Demographic trends reveal a problem which could make nonsense of all arguments about how the system is financed. If the number of healthy people paying into the system fails to keep pace with number of ill or aged people drawing on the system we have one category of financial problem. I'm also going to bypass that one.

The catch comes when we consider that present medical expenditures are tied to services which are expensive at present, and have been rising in cost faster than inflation since about 1950. If the people who deliver those services are overwhelmed by the number of sick people needing services, the cost of those services will simply keep rising until it breaks whatever provision for funding has been prepared. At some point in the future, the present paradigm of medicine simply will not work.

Continuing healthcare business as usual, with limited truly original research and enormous costs for services, particularly those of dubious value, doesn't merely allow this possibility; it almost makes it inevitable. A slowly spreading retroviral disease with a thousand manifestations would definitely do so.

I'm going to go out on a limb and make another controversial claim. Most of the present healthcare advantages we in the developed world enjoy are not much tied to those office visits we directly associate with healthcare. (Those who have lived outside this developed world can testify to the validity of my observations.)

The big advantages we enjoy over our ancestors come from such things as clean water, adequate supplies of healthful food, proper waste disposal and prevention of disease by vaccination or quarantine. (Hospitalization can be considered a form of quarantine even when it is not called such. Hospitals can protect a populace even if they fail patients.) Most people who visit doctors will either get well without treatment, or become regular users of a kind of revolving door. Medical success stories are not as high a percentage of patients as we would like to believe.

It is not at all clear to me that financial incentives for medical practitioners favor those who actually prevent or cure disease over those who merely keep sick people alive and prolong suffering. The major skill required for financial success seems to be placing defensible diagnostic codes on forms. In fact, there is a thriving industry in some places doing this entirely without patients. Estimates place the cost at several times the entire federal expenditure for biomedical research.

Do you see why I feel the present system is broken?
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."
  1. anciendaze
    Wouldn't it be nice if politicians hedged the bets they make with public money? Just for example, suppose they hedged the bet they are making that there are no chronic infectious diseases slowly spreading through the population, and leading to full disability years later. Even 0.1% of spending for medical research would represent a huge increase.
  2. markmc20001
    Good point. Eric Cantor could be just hedging his portfolio, but is essentially betting against the USA with his portfolio even if it is a hedge. Not a good political move, but it was a story the mainstream media gave him a "pass" on so it didn't seem to make a difference.

    The funny thing is 10 year treasuries rallied from a yield of 3.00% to 2.21% when the debt ceiling circus took place. Can't do the math at the moment, but it is at least 20% principle gain. The whole world has no where else to put all the money when the stock market tanks. What was interesting was Gold and silver rallied, unlike in 2008 when everything got liquidated.

    It's a better trade to be long treasuries when the market is collapsing obviously. I wouldn't buy them here though, probably good time to stay out of the market completely.

    Get long chickens, and gold!
  3. anciendaze
    Disclaimer: in the above comment, I am not defending the congressman, I scarcely know anything about him. From the tiny bit of solid fact I was able to extract on-line, I would be willing to make a modest wager than some of his (financially) conservative investments may well be in institutions that hold T-bills. When it comes to his own money, he doesn't know what will happen next, and is hedging his bets, assuming he knows his own investments better than he knows the federal budget. There remains the possibility he is clueless.

    Since I started this series, I have had some interesting private comments. I've been accused of supporting three different political factions. I've been asked for personal financial advice. I've even been asked to predict what will happen next week.

    In case anyone missed the point, I'm still figuring out what hit us all in 2008. My knowledge of current politics is very limited, because there is only so much entertainment I can tolerate in a given time span. The supply far exceeds my demand.
  4. anciendaze
    Very interesting, but not large enough to offset the political losses likely to result from this disclosure. A member of Congress who can't aim a billion or two per year to a district or constituency is hardly worth mentioning.

    Added: I just checked financial news before writing anything foolish. (I may still write foolish things, but I think about them first.) If congresscritter Cantor is dabbling in naked shorts on U.S. T-bills, he may be in for a learning experience.

    First, an explanation about shorts. You are betting against the future value of some asset. Your maximum profit results when the value of that asset falls as far as possible below the short value, you can't go below zero. (In the case of 20 year T-bills this might mean anyone employed by the U.S. government would lose their job, insurance and pension. Directing government spending to constituents would also cease.) On the flip side, your maximum losses are unbounded. Should the asset rise in value, you will have to make up the difference between market value and the value you chose.

    The connection with today's financial news is that weakness in sovereign debt of Eurozone nations makes U.S. T-bills relatively attractive. This causes trillions of dollars worth of Euros to slosh from one continent to another, pushing up the price of T-bills quickly. (Really hard currencies, like Swiss Francs, don't have room for all those funds. Currencies like the Yuan carry serious political risks. Gold is already priced out of sight.)

    I'm always interested in how officials in these situations are expected to realize ill-gotten gains. If he did make a windfall from a trifling investment it would be reported to the IRS, and show up on his tax return. The next thing on his schedule would be either impeachment or lynching.

    My reading of the political strategy is that the idea was to tie Obama's hands before the 2012 elections, making him a one-term President. The idea that he can't be President if there is no U.S.A. has been suggested. It seems a bit much, even for current politics.
  5. markmc20001
    Not sure if you were familiar with this little bit of news....

    Eric Cantor's glaring conflict of interest
    He's the GOP's chief debt ceiling negotiator. He's also invested in a fund that will skyrocket if there's a default

    When Eric Cantor shut down debt ceiling negotiations last week, it did more than just rekindle fears that the U.S. government might soon default on its debt obligations -- it also brought him closer to reaping a small financial windfall from his investment in a mutual fund whose performance is directly affected by debt ceiling brinkmanship.

    Last year the Wall Street Journal reported that Cantor, the No. 2 Republican in the House, had between $1,000 and $15,000 invested in ProShares Trust Ultrashort 20+ Year Treasury EFT. The fund aggressively "shorts" long-term U.S. Treasury bonds, meaning that it performs well when U.S. debt is undesirable. (A short is when the trader hopes to profit from the decline in the value of an asset.)

    "If the debt ceiling isnt raised, investors would start fleeing U.S. Treasuries," said Matt Koppenheffer, who writes for the investment website the Motley Fool. "Yields would rise, prices would fall, and the Proshares ETF should do very well. It would spike."

    http://www.salon.com/news/politics/war_room/2011/06/27/eric_cantor_conflict_of_interest
  6. anciendaze
    I wasn't trying to inspire conspiracy theories. The people I was referring to were all politicians elected in the last six years, including the latest crop of congressional freshpersons. The result of the latest round of debate about debt was to scare people all over the world about possible U.S. default. Did any of the participants plan on this? I think not.
  7. markmc20001
    removed post, off topic/misinterpretation.
  8. anciendaze
    The end of the world has been announced many times. (There is even a book titled "A History of the End of the World".) Many individuals have met their ends, but survivors keep picking up and carrying on, even after events such as the black death. We don't face a crisis which is likely to wipe out 1/3 of the population of developed nations in short order.

    All the people and tangible assets needed for recovery are present. The problem lies in putting them to work solving problems instead of creating these to score political points or make short-term economic gains. A major part of this problem will be convincing people their efforts are going to solve problems which will benefit them. Jawboning the masses is not going to be enough.

    Simplifying the whole social and economic system until everyone understands how it works is probably beyond reason. Past simplifications have tended to be brutal and drastic.

    Regulations which anticipate everything people will dream up to exploit trust are also unlikely to ever be complete. Attempts at this approach in the legal system have led to some notorious miscarriages of justice, though attorneys have profited considerably, regardless of whether society wins or loses.

    We need to separate the problem of skill in accomplishing desired results from ability to check that these have actually been accomplished. Compare this to mathematics where it is possible to check that a solution of a problem works even if you lack the ability to understand how it was discovered. This state of affairs did not spontaneously spring into existence, it was developed over a period of centuries, at the cost of many false starts and a great deal of mental effort.

    Present legal, financial and medical systems are designed so that feedback is to be provided by professionals who have a major interest in preserving their own advantages. We have reached a level of civilization where those advantages can no longer be maintained by force, (though I can think of countries which have not realized this). It is imperative that transparency and intelligibility function in ways that allow individuals of normal ability to make rational decisions about their economic well being, non-criminal activities and health.
  9. xrayspex
    Also, maybe this will be moot but then it will be the end of world if so......would you feel safer owning a house in a stable area of US right now or having a chunk of change in the bank? Will FDIC insured remain reliable?
  10. xrayspex
    Interesting discourse, thanks. I love trying to understand economics.....I was convinced of doom in 2002 but then if they didn't come up with next ponzi scheme and the markets started soaring until 2008. Will they always devise another scheme...things continue up and down into the future like in the past?