Unintended Consequences

I have just read Unintended Consequences by Edward Conard. He was the managing director of Bain Capital, the company established by Mitt Romney and his mates. He makes some interesting points about the causes of the Global Financial Crisis.

Part of the problem was that the United States and the rest of the world had a surplus of risk-averse, short-term capital.

Risk averse short short-term capital will only fund investment, if equity underwrites the risk. The United States and the rest of the world have a shortage of equity and risk taking rather than a shortage of capital more broadly.

Low-income households are far more disposed to consume than to invest. They tend to sell assets to increase consumption.

What little the middle class saves largely funds their personal housing. Housing investment does little to increase growth, productivity, employment and wages. Middle class saving over an above housing largely provides risk-averse short-term saving. They demand capital preservation and the right to withdraw their saving and consume them at any time. This type of capital underwrites too little risk to grow the economy.

Economic activity is proportional to risk taking. The willingness to take a risk drives both investment and consumption.

Investments to produce innovation are risky, and often produce no value at all. When they work, innovation create enormous increase and in value and subsequent economy activity.

Equity investors have the right to whatever profit is left over in a business after everyone else has been paid. Unlike equity investors, short-term debt holder demand capital preservation and the right to withdraw and consume their savings at any time. Because of these demands, short-term debt may fund investment, but only if equity holder underwrite the investment risk. Short-term debt bears too little risk to grow the economy. The amount of equity and its tolerance for risk grows the economy.

This difference in risk tolerance has a significant impact on the capital available to underwrite risk. The deferred consumption of the middle-class consumers largely yields risk-averse debt. These investors refuse to underwrite risk. Instead, they demand government guarantees as a condition for making their savings available for investment. These guarantees include government-issued treasuries, municipal bonds, and the debt of government-sponsored entitles like Fannie Mae and Freddie Mac as well as Federal Deposit Insurance. With an abundance of risk-averse debt flowing in to the United States from the trade deficit, additional risk-averse domestic debt is of marginal value to growth of our economy.

There is plenty of risk-averse capital to fund increased investment. So much so , that an abundance of investors willing to buy debt contributed to the growth of sub-prime mortgages and the erosion of credit standards that triggered the financial crisis. What was needed was more equity.

Traditionally, economists define saving as the accumulation of deferred consumption, because saving defined in that way are straightforward to measure. But savers largely lend deferred consumption as short-term debt. Successful risk taking that creates innovation large creates equity, not the accumulation of deferred consumption.

Government guarantees—the promise to cover losses with future tax increases, if necessary―encourage risk-averse offshore investment in the United States via government guaranteed debt.