Bigger Government? Or Not?

An animated discussion about our financial woes over dinner in Krakow, my colleague and I allocating core blame differently.

He (accountant) blamed technical accountancy practices for allowing exotic transactions which gave paper profits increasingly detached from reality.

I (former civil servant) blamed the government for not spotting the bigger picture trends and taking action to curb irrational accounting – which is after all what they are paid to do, namely set the overall rules (and intrinsic incentive arrangements).

The example given was this. X takes out a mortgage. The bank calculates that over 20 years it will make a profit of £y per annum, totalling £z overall. The bank sells that ‘box’ of long-term profit to someone else for a sizeable sum. In accounts terms the bank has made a sudden nifty profit for this year’s tax return. That asset box in turn can be sold on. And on. And on.

But what is really happening in all this? The further the financial transactions drift away from the real-life prospects of the person taking the loan, as computers and accountants come up with ever more ingenious ways to manipulate the likely cash-flow, the more the whole system starts to depend on the assumptions in the computer programme.

Those assumptions may be unknown to the people in the transaction chain, or unwise, or both.

In a word, a systemic risk element is growing fast. Until some of the deepest assumptions collide with real life – as they must, sooner or later – and down we all go, like those cartoon characters who cheerily march out beyond the cliff edge into thin air.

This captures it all elegantly:

When we use data to take financial decisions, decide how much capital to keep and so on, we should be aware that the data we use contains some information but that relationships that hold one day will not hold precisely the next day. We should stand back and think conceptually about the risks that financial institutions are taking.

… But who cares about trust and reputation when we believe that everything will be looked after by the regulators or by deposit insurance?

As far as a company is concerned, compliance with regulation has become more important than trust. The market has been allowed to generate crude economic efficiency, but trust has been crowded out by regulation.

Spot on.

Right at the heart of it all is the simple yet profound idea that if you have the power to force through an outcome, your decisions are unlikely to be as sensible as those of someone who has to use persuasion to get results. The notion of so-called moral hazard:

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.

Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly.

Essentially, profit is privatized while risk is socialized.

Which is why the etatist, clumsy solutions proposed now by Guardianistas such as Will Hutton will make everything far, far worse.

Because all that will happen is that risk taking will become even more stupid. The state must simply grab more and more, as it flails around trying to solve the problems it has created.

The whole UK government approach run by Gordon Brown for twelve years turns on a Micawberish "something will turn up" bet, which in practice means dumping the costs of Labour incompetence selfishly on millions of innocent people. Namely our children.

These issues are difficult. We should take a strategic view on how we want to manage them.

So here’s the (only) question for the public. Do you favour: