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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?

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
    My habit of short naps, plus news of ongoing chaos on markets, has produced a dream I would hesitate to call prophetic. I was trying to pay a bill at a store with cash when the clerk told me I shouldn't be using money unless I had a graduate degree in economics, it was simply too risky for an amateur to try to understand what it was worth. When the dream ended, I was trying to figure out what I could barter for food.

    Any oneirologists out there?
  2. Enid
    Interesting discussion here - thank you both. I firmly believe in the principle of medical research for cure (for reasons given) as being the most cost effective and least likely to overwhelm services in the long run.
  3. anciendaze
    Thanks for the vote of confidence, Alex.

    I just realized that I dropped something, or fooled myself into thinking I had written it. Here are some paragraphs which should illustrate the application of my 'end-to-end checks' in a financial context.
    How do you apply this idea to prevent financial debacles? You draw a line around a section of the business, and treat it as a black box. If you see risky loans going in one side, and AAA bonds coming out the other, you know something is wrong. You don't need to understand the internal workings of the box. Either someone is lying about the risk, or the company performing the transformation is assuming the risk.

    A similar procedure could have shown that Bernie Madoff was running a Ponzi scheme years before it collapsed with a loss of $80 billion. Money going in and going out didn't show the predictable effects of investment in anything. He was doing something equivalent to printing money. Was he a treasury or central bank? No.

    At this point we run into another moral hazard. Madoff had wealthy and powerful friends. Many people who invested with him didn't care how he made them money, so long as he delivered fat profits. With the reasoning above we could guess that he was up to no good. How many of those burned by his scheme thought they were insiders in a rigged game?

    The larger financial debacle reveals that corporate balance sheets may hide more than they reveal. If you knew which corporations were linked, you could then proceed to evaluate their balance sheets in order to make a rational decision. The final stage of the collapse of Wall Street firms revealed how they had transferred risk for assets which remained on their balance sheets. In the end, the CEOs of those firms had to sit in one room and work out how closely they were linked before they realized the extent of the danger. There was a major lack of transparency which defeated attempts at rational investment. Why? Because those same firms were making money from irrational investors.

    If you spend years encouraging people to behave irrationally, and undermining the basis for prudent decisions, you can hardly complain when irrational behavior turns against you.
  4. alex3619
    Hi Anciendaze, I have reached similar conclusions about the medical system in its broadest sense.

    Disability rates are climbing as the number of chronically ill rises but lifespan is now longer. This is only modified for ME by the apparent higher than normal death rate.

    Acute illness, rather than chronic illness, gets the majority of medical research funding. Drug companies are the exception to this, but they are looking at palliative treatments, not underlying basic research that could eventually lead to a cure. For the size of the ME problem it is one of the most underfunded diseases there is, probably the most underfunded common disease.

    Governments are not happy to spend more money on medical research. However, they like to focus on ways to slash costs at the expense of the sick. This does not address the problem, only the current budget, and the underlying problem actually gets worse because it was not addressed.

    So the problems keep getting worse, and the "solution" is to slash the budget. This is the same type of response as balancing the budget by borrowing more money. The underlying problem is always rising.

    Slashing medical research, particularly fundamental research on disease as opposed to applied research, is a direct attack on future economic stability.

    I proposed a campaign many months ago to push for a funding solution. The aim was to spend 0.1% of the cost of any particular disease on medical research into that disease. That way funding is proportional to cost. At the moment funding is proportional to policy and lobbying, and this is only contributing to ongoing economic dysfunction.

    If a government wants to slash long term costs, and not just balance the budget for this year, it needs to push medical research. For the most part this should be basic research into disease processes. Once a new disease process is identified, private concerns will push research into it - there is money to be made.