Shifting Risk: The Divorce of Risk from Reward in American Capitalism

By Prasch, Robert E. | Journal of Economic Issues, June 2004 | Go to article overview

Shifting Risk: The Divorce of Risk from Reward in American Capitalism


Prasch, Robert E., Journal of Economic Issues


After incurring losses of $1.22 billion in 2001 and $1.27 billion in 2002, the senior executives of Delta Airlines quietly funded a special account to ensure that their own pensions would be completely protected in the event of that airline's then widely anticipated bankruptcy. As to the pensions of all other employees, their level of underfunding rose from $2.4 billion to $4.9 billion during 2002. In the event of bankruptcy, the funding of their pensions would be left to the vagaries of the legal process ("Delta Air Moves to Secure Pensions of Struggling Carrier's Executives," Wall Street Journal, March 26, 2003, C7). This story suggests the theme of this paper. Just who, in out deregulated form of hyper-capitalism, are the risk takers? Additionally, are the actual risk takers of our age being compensated for the risks they routinely undertake with additional rewards?

As the Delta Airlines example suggests, the shifting of risk does not necessarily take place through "voluntary" or "compensated" transactions, as the finance textbooks would lead us to believe. Yes, it is true that risks are often traded by firms and individuals in complex commodities, bond, asset, and derivative markets. Yet it is also evident that in the event of unequal bargaining power, legalized protections, and asymmetric information we also experience a tendency for a separation of reward from risk. To be specific, we have seen, and can expect to continue to see, the systematic shifting of risks toward those who cannot afford them, cannot control them, and do not want them.

Admittedly, the size and scope of this shift is difficult if not impossible to quantify. The reason is that these shifts are infrequently the result of explicit negotiations or market transactions. But a lack of easy quantification should not, as it too often is in economics, be taken as evidence that the phenomenon in question is not occurring. Indeed, the continuing divorce of risk from reward represents an important contributor to the sense of insecurity that is increasingly evident among so many middle and working class Americans.

Deregulation in general, and financial deregulation in particular, is valued by its beneficiaries in part for its ability to separate risk from reward. Modern financial markets enable management, major shareholders, and other of the firm's "insiders" to shift risks away from themselves. While professional insurers, speculators, and hedgers may accept these risks for a fee, it is clear that some of these risks can also be shifted toward smaller and less informed stockholders, bondholders, employees, customers, and other stakeholders, including the general public. These latter groups, if they understand these risks at all, are generally less willing and frequently less able to bear the risks they are being forced to shoulder. Sadly, it is often the case that they are not even aware that they are being subjected to them. (1)

The Economics of Shifting Risk

Consider, in light of the above, the following statement from a conventional finance textbook:

   These considerations of risk and expected return lead to a general
   principle of great importance. Investors will make a risky
   investment only if they believe that the expected return justifies
   the risk. That is the key idea of the risk/return (or more exactly,
   the risk/expected return) trade-off. It is simply a fact of life
   that high expected return and high risk normally go together. (Kolb
   and Rodriquez 1992, 10, italics added)

This now-conventional understanding of the relation between risk and reward depends upon a crucial premise: that the risks in question be entirely and voluntarily borne by either (1) the party whose activities and decisions are creating the risks in question or (2) by another party who has contracted with the first party, either directly or through one or more intermediaries, to accept the risk in question for an explicit fee. But what happens to the validity of this conventional perspective in the event that one or more of its crucial, and generally unstated, premises rail to hold? Indeed, there are several substantial reasons to suppose that in the American economy risks will be separated from rewards and shifted away from decision makers and the economically powerful.

Limited Liability

In American capitalism decision makers routinely, if not typically, enjoy legal protection from full responsibility for the risks they generate. This is most apparent when we consider the legally limited liability that has been awarded to shareholders and managers of incorporated firms (Eeghan 1997).

In the event that a firm with legally limited liability faces a financial debacle, its creditors can demand, at most, the sale or liquidation value of the firm's assets unless they can prove fraud or criminal negligence (a nontrivial task). The private assets of shareholders and managers, beyond what they have invested in the firm, are legally protected from the firm's creditors. This arrangement works exactly as it was designed. It "socializes" risk while "privatizing" reward by legally sanctioning the separation of decision makers and owners from the full consequences of their decisions and actions.

This tendency has been exacerbated by a recent legal "innovation" called the limited liability partnership (L.L.P.). Dating from the early 1980s this new legal form originated, as have so many of this nation's most irresponsible ideas, in Texas. As was intended, it quickly spread to cover partnerships in professions such as law and accounting. These fields had formerly, and with clear deliberation and intent, been excluded from the privilege of incorporation in order to protect the public from the unscrupulousness, negligence, or dishonesty of persons in those professions in which performance is most difficult to monitor. The consequences of this Texas law were as substantial as they were predictable. Previously, it was understood that one of the few, perhaps only, effective checks on the professionalism of lawyers and accountants was peer review by one's fully liable partners. To illustrate this point, consider what the actions of the Chicago head office of Arthur Anderson might have been if they had understood that all of the firm's partners were fully liable for the Houston branch's handling of its Enron account.

Of course, thanks to limited liability, former Anderson partners, who were in a position to understand and act on the developing crisis, were fully protected. Enron's shareholders, pensioners, and creditors, who could not be expected to either understand or anticipate the lax or corrupt accounting practices of Arthur Anderson, are left in penury. In an episode so emblematic of the "new economy," Anderson partners earned large rewards by overseeing and concealing the generation and shifting of substantial risks to employees, passive shareholders, and pensioners, most of whom neither understood nor desired such risks. (2)

Asymmetric Information

A second reason for the separation of risk from reward is the widespread presence, especially in financial markets, of what economists term "asymmetric information." This describes situations in which one party has privileged access to the specific qualities or characteristics of a situation or contract where another does not. In such a case a firm's "insiders" may know that its decisions have created new risks, but "outsiders," either those with whom the firm is dealing, or third parties such as the public at large, may substantially underestimate these same risks.

In such cases insiders have a financial interest in having their counter-parties or the larger public remain ill-informed about the risks in question. Additionally, nonfinancial examples also evoke this problem. Here in the United States these include such industries as radium, asbestos, tobacco, and now beef. The motivation to increase sales, exacerbated by the institutionalized myopia of American firms, ensures that dangerous drugs, treatments, products, and practices are routinely promoted and distributed while known risks are as routinely covered up (Markowitz and Rosner 2002; Eric Schlosser, "The Cow Jumped over the U.S.D.A.," The New York Times, January 2, 2004, A19). (3)

It is clear that the same behavior typifies American financial markets. Day trading, "aggressive" and fraudulent accounting, front running, market timing, dotcom IPOs, telecom stocks, and the highly suspect "analysis" forthcoming from major investment banking firms, along with numerous other dubious adventures of the past decade, each and severally affirm that the "sales side" of the market routinely, and as a matter of course, uses its superior knowledge of financial products and markets to misrepresent the qualities of overly risky assets so as to sell them to ill-informed, misinformed, and periodically outright defrauded customers (Cassidy 2002). (4)

By contrast with the above, the premises behind the ideal that the market is working so as to ensure that risks and rewards remain linked are free entry and exit, perfect information, and costless mobility in both labor and credit markets in addition to no externalities. The complete absence of the corporate form is another crucial, if unstated, premise. (5) In the economies of the real world each of these premises is most conspicuous by its absence. Common sense suggests that theoretical or policy conclusions derived from these theories need to be viewed with some skepticism.

Externalities

In some instances, the shifting of risk to third parties who are not a party to the original contract is an inherent quality of the activity in question. Such eventualities, called externalities, are well understood by those working in environmental economics, but there is no reason why such an analysis can not be applied to financial markets.

Although it was repeatedly denied by mainstream economists during the 1980s, and especially in the 1990s, thinking adults have always known that financial markets are prone to what were once called "panics" or "crashes" and are now called "contagion." If the failure of a prominent financial firm can precipitate a sudden and dramatic reassessment of the riskiness of a particular class of assets, thereby inducing a flight from qualitatively similar assets, then a crash may result. Given how conscious the public, and often insiders, are of their lack of knowledge about the actual economic circumstances and balance sheets of the large number of firms they deal with on a daily basis, and given the short period of time in which people have to decide to "sell" or "hold" once the flight from an asset begins, it is not surprising that the system exhibits signs of instability and that crashes frequently occur. Moreover, such events may follow directly from the interactive decisions of a large number of people, each of whom is acting reasonably, as that term is conventionally understood (Keynes [1936] 1964, chap. 12; Shiller 2000; Shefrin 2000).

In light of the above analysis, the question is whether decision makers account for the full impact of their actions on the level of systemic risk when they decide to purchase or sell assets, take on more leverage, put together complex derivative deals, and so on. John Eatwell and Lance Taylor summed up this issue as follows:

   [F]inancial firms do not price into their activities the costs their
   losses might impose on society as a whole. Yet those costs are a
   familiar consequence of financial failures. Not only do many
   financial dealings resemble the cliche house of cards, but one
   house going up in flames can spark a financial firestorm as loss of
   confidence sweeps away the entire street. Taking risks is what
   financial institutions are for. But markets reflect the private
   calculation of risk, and so tend to under-price the risk faced by
   society as a whole. The consequence is that from the point of view
   of society, investors take excessive risks. Totally free financial
   markets induce risks that pose a threat to the economy. (Eatwell and
   Taylor 2000, 17-18)

At one time, the above considerations were widely understood. To protect themselves and the larger society, Americans of the New Deal era demanded that these risks be subject to regulations and even a few prohibitions. Since the early 1980s we have been told that such protections are "dated" and that markets need to be "freed." What we never heard is a compelling case why.

Risk Bearing and Economic Behavior

In the case of risk, and behavior toward risk, a fairly conventional analysis of the situation, employing sounder premises, can derive a result more in keeping with the world as it is actually experienced. Let us begin with the idea that economic security is what the textbooks refer to as a "normal" good. It follows that people with higher incomes will purchase greater quantities of items such as insurance, preventative health care, preventative maintenance and safety repairs on their homes and cars, and so on, than more impecunious persons. The empirical evidence overwhelmingly supports this proposition.

Second, let us suppose, again drawing upon our shared experience, that when people or corporations are shielded from some or all of the costs of an action that is otherwise beneficial to themselves, they will engage in more of it, ceteris paribus. This proposition is simply a restatement of the idea that people, who are presumed to desire more for less, will tend to "privatize rewards" and "socialize risks" when the opportunity presents itself, unless a sufficiently strong moral sanction or legal penalty is present.

In general, those who make decisions in our largely deregulated financial markets are the wealthy, who can be presumed to make arrangements, either through legislation, incorporation, or insurance, for a substantial degree of economic security for themselves. They, in turn, can be expected to draw upon this sense of security to generate greater than the socially desirable quantity of risk for the market (and through it, society) as a whole.

Additionally, a corollary of the above is that the poor, the downwardly mobile, and some failing companies will contract into greater than socially desirable levels of risk, often out of desperation. While this may not be a problem in principle, it does exacerbate the tendency of markets to concentrate risk in the hands of those who cannot readily afford them. Since we are not yet willing to see the children of the unlucky and the unfortunate die in out streets, these increased private risks contribute to the tendency for the full costs of these risks to be passed along to the larger society.

Conclusion

After twenty-five years of privatization and deregulation Americans are left with an increasingly risky economic structure. Examples abound. In the financial sector these policies have clearly undermined the integrity of markets (Healy and Palepu 2003). Additionally, in consumer products industries from electricity to phones, Americans are being forced to accept ever-increasing quantities of price and quality risk in their multiple roles as consumers, employees, and savers.

Exacerbating these risks is the fact that the average family now spends more time in paid work than twenty-five years ago. Hence, even as the complexity and uncertainty of our lives as consumers and savers has risen, the time and energy that we can draw upon to assess and monitor out newfound and ostensibly "free" choices has declined. These trends present firms with lucrative bargaining advantages that they have readily turned to their own profit (David Pogue, "Checking Your Bill for a New Charge Called 'Oops,'" The New York Times, December 4, 2003, E1, E9).

It is not surprising that this increased level of risk is being disproportionately borne by segments of our society that are often unprepared for, even unaware of, the risks that they are being subjected to. Under such conditions it is difficult, if not impossible, to imagine how they can "price" these risks, or bargain for adequate compensation in exchange for accepting them. For example, Californians were not, and are not likely, to be paid for "accepting" the risks that were inherent in deregulated electricity markets. Indeed, it is unlikely that they would have voted for deregulation had they ever been presented with the choice. Rather, the deregulation of the electricity market is just another instance of the power of bad ideas backed by large sums of money. (6) In the "real world," the one in which most of us live, "risk-taking" consumers, employees, and investors generally (1) can not afford these risks and (2) can not control these risks. As a consequence, they (3) do not want these risks. (7)

In sum, the simultaneous increase and shifting of risk are some of the most important, if not dominant, trends of our time. Workers and investors in Enron, HealthSouth, WorldCom, Global Crossing, and literally hundreds of dotcom firms now understand this. Consumers of electricity in California, Montana, and elsewhere have also experienced the "magic of the market." Telephone ratepayers know that prices have soared since the 1970s, but they will never know how much as they confront that marvel of modern obfuscation commonly referred to as "the phone bill."

As is so often the case in these matters, Hyman Minsky was correct. In a deregulated financial system, risk has a tendency to be shifted to those least able to handle it, ceteris paribus. Today we are living in an increasingly "marketized" and "commodified" world. For most of us, this means that we are living with an increased quantity of risk, most of which is beyond our control as individuals. Add to this the continuous and "bi-partisan" retrenchment of the social safety net, and the situation is simply scary.

Notes

(1.) Several studies of the characteristics of people who are "risk averse" have been conducted. There are few surprises in this literature. It generally reports that women and those with less income, less wealth, and less schooling "prefer" less risk, ceteris paribus (Hartog, Ferrer-i-Carbonell, and Jonker 2002).

(2.) That these tendencies had little to do with new technologies and everything to do with the normal functioning of deregulated financial markets was evident to Thorstein Veblen a hundred years ago ([1904] 1978, chaps. 3-5).

(3.) The institutionalization of myopia in American corporate capitalism is too large a subject to develop here. For a relatively early and insightful examination of this phenomenon, one that is perhaps all the more remarkable as it comes from a Reagan-era Treasury official, see Jacobs 1991.

(4.) That some capable and articulate economists understood and warned us of these problems is evident from Henry Kaufman's important book (2000). Naturally, he was criticized for his "pessimism" and alleged failure to "understand the changes wrought by the new economy."

(5.) Actually, it would be inaccurate to claim that mainstream finance economists ignore the corporate form. Rather what they ignore is its attribute of limited liability. They do acknowledge that corporate shares are traded in open markets. Indeed, one of the most important theorems they have promulgated is that corporations can more vigorously represent shareholder interests by taking on much more risky projects than privately held firms, since shareholders can achieve the risk/reward structure that they desire by adjusting their portfolios. From this perspective, corporations have an ethical duty to generate more risks than privately held firms. Again it is assumed, without any discussion, that these additional risks will be completely and exclusively borne by the firm's shareholders (Bodie and Merton 2000, 10-13).

(6.) I have never been comfortable with the metaphor of the "marketplace of ideas." But over the past ten years I have come to appreciate it more and more, although I suspect that most people who use it have a "perfectly competitive" market in mind. However, casual observation suggests that in our era the demand for ideas, like that for consumer goods, becomes effective when someone wishes to pay for them. In this sense the "marketplace of ideas" operates like an auction market: Ideas backed by large sums of money "win" and the others "lose," ceteris paribus.

(7.) If neoclassicals took the notion of scarcity as seriously as, following Wesley Clair Mitchell (1912), I have in the above analysis, they would be compelled to concede that consumption is necessarily an inexact practice as it involves purchasing a large selection of commodities in small batches under binding time and information constraints. It follows that the time that can be devoted to any single purchase or decision must be limited and the final result will be imperfect. I will leave it to the reader to speculate on why it was that Mitchell's simple insight into the difficulties of shopping in light of the reality of limited time and information has been lost to the mainstream economics literature and how it came to be replaced with the presumption that consumers face zero transactions and information costs when using markets. Could it be that there was an implicit, if not explicit, agenda to promote the idea that "free markets" are always efficient for maximizing consumer welfare?

References

Bodie, Zvi, and Robert C. Merton. Finance. Upper Saddle River, N.J.: Prentice Hall, 2000.

Cassidy, John. dot.con: The Greatest Story Ever Sold. New York: HarperCollins, 2002.

Eatwell, John, and Lance Taylor. Global Finance at Risk: The Case for International Regulation. New York: New Press, 2000.

Eeghan, Piet-Hein Van. "The Capitalist Case against the Corporation." Review of Social Economy 55, no. 1 (Spring 1997): 85-113.

Hartog, Joop, Ada Ferrer-i-Carbonell, and Nicole Jonker. "Linking Measured Risk Aversion to Individual Characteristics." Kyklos 55 (2002): 2-26.

Healy, Paul M., and Krishna G. Palepu. "How the Quest for Efficiency Corroded the Market." Harvard Business Review (July 2003): 76-85.

Jacobs, Michael T. Short-Term America: The Causes and Cures of Our Business Myopia. Boston: Harvard Business School Press, 1991.

Kaufman, Henry. On Money and Market: A Wall Street Memoir. New York: McGraw-Hill, 2000.

Keynes, John Maynard. The General Theory of Employment, Interest, and Money. 1936. Reprint, New York: Harcourt Brace, 1964.

Kolb, Robert W., and Ricardo J. Rodriguez. Principles of Finance, 2d ed. Lexington, Mass.: D. C. Heath, 1992.

Markowitz, Gerald, and David Rosner. Deceit and Denial: The Deadly Politics of Industrial Pollution. Berkeley: University of California Press, 2002.

Mitchell, Wesley Clair. "The Backward Art of Spending Money." American Economic Review 2, no. 2 (June 1912): 269-281.

Shefrin, Hersh. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Boston: Harvard Business School Press, 2000.

Shiller, Robert J. Irrational Exuberance. Princeton, N.J.: Princeton University Press, 2000.

Veblen, Thorstein. The Theory of Business Enterprise. 1904. Reprint, New Brunswick, N.J.: Transaction Books, 1978.

The author is Associate Professor of Economics, Middlebury College, Vermont, USA. He would like to thank Laurel Houghton and Kevin McCarron for their assistance at various stages in the development of this paper. Earlier versions of this paper were presented to the American Association of Law Schools annual meetings in Atlanta, Georgia, and to the Association for Evolutionary Economics annual meeting in San Diego, California, January 3-5, 2004.

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