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Moral Hazard, part five

Blog entry posted by anciendaze, Aug 5, 2011.

A long list of people who have tried to analyze wars from an economic standpoint have ended up with contradictory conclusions. In "Vom Kreige", Clausewitz couldn't find any separate purpose for war. "War is the extension of politics by other means." (Possibly true, but this begs another question. Two very different books to tackle the subject seriously are "The Statistics of Deadly Quarrels", by Lewis Frye Richardson and the more recent "The War of the World" by Niall Ferguson.) My own take is that wars simply do not make economic sense.

We also have the aphorism "The first casualty of war is truth" (which may go back to Aeschylus.) Nowhere is this more true than in the economics of war. Nations use the coercive power of the state to impose taxes, seize property, control prices and conscript individuals to support wars. A little thought will show that no realistic compensation for lost lives, lost limbs or lost minds is possible, even before we consider material costs. It is hard enough to imagine sane individuals doing many of the jobs required in war for money, let alone in appalling working conditions typical of combat. The corresponding cost of labor is simply incalculable. Most of this cost is off the balance sheet, so far as such things exist during a war.

During WWI, economic dislocations caused by mobilization and diversion of resources from a civilian economy were often made up by buying goods on credit from non-belligerents. The U.S. was in an especially good position to supply the western allies. The credit of these nations was based on the same power to coerce their own citizens they used to prosecute the war, so it seemed obvious those governments would not default unless they fell. Whatever the populace of those countries was doing, the governments were fighting for survival. Governments in Russia, Turkey and the nations of the central powers did collapse. What about more democratic nations?

While the systems of government remained in place, most specific governing coalitions fell after the war. France and Italy went through multiple changes rapidly. In Britain, governments headed by David Lloyd George survived until 1922. (The same year brought Benito Mussolini to the head of the Italian government. In that war, Italy was on the winning side. I still can't make sense of Mussolini's rise to power. Perhaps some reader can explain this to me.) By 1922, none of those who led their nations during the war still headed governments. Any promises they had made were beyond their power to deliver. The people who avoided defaults on sovereign debt were generally the central bankers, who could appreciate the dangers of economic collapse if the full faith of governments was not enough to cover those loans. A great deal of fancy footwork followed.

Today it is quite difficult to imagine the faith people had in the British Empire at a time when "the Sun never set" on it. From 1752 on it had issued 'consols' (consolidated bonds). The extraordinary thing about these bonds is that they paid interest, but never matured. The British Empire would hold the principle in perpetuity, making no definite promise to redeem it at any particular date. Holders of these bonds had a guaranteed interest income which gave them a rarefied status beyond the 'coupon clippers' who redeemed bonds piecemeal.

With such background, nobody was very concerned that the British Empire would default or miss interest payments. Holding sovereign debt from them was like having gold in the vault under the Federal Reserve Bank of New York. (Fort Knox did not yet exist.)

French politics might be turbulent, but French belief in sound money was almost religious dogma. That nation had its own very special vault for the gold backing its currency, and kept gold going into it, whenever possible.

Italy was, well, eternal Italy. No one was entirely sure when it would get around to repayment. Should it default, international finance would take a big hit, but generally it seemed the world would survive. Most knowledgeable people believed something reasonable could be worked out, given time.

The catch in all this was the huge economic vacuum created by the war. Most of this had never been on the books. It would swallow any possibility of reparations, plus a substantial portion of the sovereign debt owed by surviving nations. When it did, those loans being treated as absolutely sound would be revealed as nothing more than I.O.U.s. The problem was that those loans formed the base of a huge pyramid of financial obligations extending throughout western economies, and no one had seriously considered the risk.

Having a bond backed by the full faith of a sovereign government which survived the war might be like having gold in a bank, except that it was not liquid. This gave rise to a series of loans using these debts as collateral. This allowed the holder to profit from the bond, when it was redeemed, and still spend the money it represented to make investments in the present.

As before, when money is loaned out, it is counted repeatedly. There were restrictions on this process in ordinary banks trading government bonds. Despite what you may have heard, there was a Federal Reserve System in the U.S. (It was created in 1913, in response to a crisis in 1907.) These banks operated as central banks, meaning they could issue federal currency. They also set reserve requirements for other banks they dealt with, and controlled the rediscount rate at which they bought up loans made by those banks.

The purpose of these restrictions, taken altogether, is to control the "multiplier" by which the money deriving from the system exceeds actual money going in. Central banks in the U.S. were still fairly weak in their legal powers compared to those in some other countries. What's more, there was no Securities and Exchange Commission (SEC) until 1934. Numerous clever people figured out ways around both government and institutional controls. The result was that the effective multipliers for many investments were practically unlimited. Leveraged investments made many people fabulously wealthy -- while the markets were only going up. (Those who remember "Little Orphan Annie" will think of "Daddy Warbucks".)

Exactly what caused the crash has been the subject of many analyses. I won't attempt to pin the blame. The run up was a classic economic bubble, which had to fail by some sequence of events. Exactly how it failed interests me much less.

One of the classic errors in economic thinking is equating costs and values. Students of Thorsten Veblen might expect this among the extremely rich dedicated to "conspicuous consumption". You can also find this error in corporate board rooms, where it is very difficult to tell people, "you spent all this money and gained nothing except a painful lesson". Telling county commissioners the same thing may be even harder. Astonishingly, you can trace this same error in the Marxist theory of value, which is entirely based on human labor. Desire for an egalitarian result causes these theorists to equate values which are bizarrely mismatched.

(I suspect even a dedicated Marxist would prefer a meal prepared with modest effort by a skilled cook to my own results in the kitchen, achieved with far greater effort.)

The value which disappeared into "The Great War" was so large it is unlikely to ever have been properly estimated in any officially published numbers. The value which emerged was decidedly negative.

The money supply seemed large, as long as various debts resulting from that war were expected to remain good. This major deception from the top on down spawned a horde of smaller deceptions, resulting in a bubble based on bad credit. Many numbers showing profits during this period were not tied to any value whatsoever.

There was a fundamental lack of honesty and transparency in the entire process. Insider trading was rife. This is a regular symptom of lack of transparency. If everyone can tell what is going on, the potential for insider deals is greatly reduced, and the chances of being caught in criminal wrongdoing are increased. Crime and obscurity are partners.

More recent economic problems illustrate a subtle threat posed by complexity. Even if all the data were available very few people would be able to interpret it. This fits a type of economic theory based on "bounded rationality" of participants. Increases in complexity can push so far beyond bounds that virtually everyone involved may be acting irrationally.

(This is a theme of mine beyond this series of posts. Don't assume anyone really knows what is going on. I have encountered examples of unbelievable errors in several careers, even in cases where the consequences could be sudden, violent death. I am therefore loathe to rule out incompetence without strong evidence of intent. The possibility nobody seems to consider was illustrated long ago in a cartoon by Sidney Harris: "The experiment was more of a triple blind. The patients didn't know; the doctors didn't know, and it turned out nobody knew.")

This post has also grown to unwieldy length. I will come back to the connection with our healthcare system in the next post. You might try to abstract the principles of huge and persistent economic errors I've touched on so far before I present my own explanations.
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."