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When All Else Fails: Government as the Ultimate Risk Manager. . - Review - book review
Challenge, July-August, 2002 by Robert Shiller
When All Else Fails: Government as the Ultimate Risk Manager. By DAVID A. Moss. Cambridge: Harvard University Press, 2002. Cloth, $39.95. 464 pages.
Some of our most important devices for managing our personal economic risks are provided by the government. Government-sponsored risk management is fundamentally different from government redistribution of income or welfare. It protects each individual's wealth from adverse shocks, thereby helping even those of us who have achieved higher economic status to maintain that status in the face of random shocks. By some accounts, such protection of wealth should not be the role of the government, but in fact it has become one of its major activities.
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David Moss has written a highly informative book about the government's significant role in managing our individual economic risks. He shows us the landscape of this government risk management by considering all the different forms it entails. The federal and state governments in the United States have provided limited liability for investors, protections for our money supply, bankruptcy laws that cancel individual debts in bad circumstances, accident insurance for workers, unemployment insurance, survivors insurance, disability insurance, old-age insurance, product liability laws, disaster relief, environmental liability law, and insurance on insurance through state insurance guarantee funds. Considering all these together, we see that there is an enormous government-sponsored risk-management system that protects all of us.
Moss enlightens us by reporting on the historic debates and arguments that led to the first establishment of these institutions in the United States, and to the subsequent modifications and improvements of these institutions. These debates are fascinating, for they reveal the tenuousness of the initial ideas, the difficult struggle with the application of the concepts of risk management, and the interplay between real-world experience and concept development. Revisiting the debates is a wonderful device for helping us understand the how and why of risk management as it exists today.
Moss distills from his analysis of two centuries of experience four main classes of problems that explain why the government has a fundamental role in the management of individual risks, why we had best not leave all our individual risks to our private management. The first class is asymmetric information problems, notably moral hazard (people may deliberately cause losses so they can collect on their insurance) and selection bias (people may buy a large amount of insurance when they know there is likely to be a large loss). There is a role for government-mandated insurance because the government is sometimes in a better position to monitor moral hazard, and the government can eliminate selection bias by requiring coverage for all. The second class is perception problems. We cannot expect all people to understand their risks and to deal with them in an enlightened manner. Here, Moss considers some important principles of both psychology and behavioral finance. The third class is commitment problems, that peo ple cannot credibly commit or cannot make promises that we know will be kept. For example, children cannot make promises to pay out of their own future income, and parents cannot commit their children's future income. Such problems limit people's ability to make contracts that will manage their own future risks. The fourth class is externality and feedback problems. Risks created by one firm may be suffered by society in general, and aggregate risks may feed on each other and thereby be amplified, unless the government makes fundamental structural changes to disrupt the feedback.
One example of this government's role in promoting risk management can be found in the development of limited-liability law. A major turning point in history occurred in New England in the early nineteenth century. Notably, New York State enacted the world's first general law of incorporation in 1811, and this and subsequent laws set the stage for the general principle of limited liability for shareholders. The 1811 law made it automatic that any business satisfying minimal requirements could incorporate. By 1830, the concept of limited liability was well established in New York and New England. The limited-liability laws unequivocally specified that stockholders could not be sued for more than the capital they subscribed. Before this time, incorporation was generally a special privilege to well-connected people, and consequently few businesses incorporated. Moreover, before this time, stockholders generally were jointly and severally liable for the losses of the company, meaning that if the company had larg e losses, creditors could sue to take all the wealth of any stockholder who had assets to seize, until the company's debts were paid. Thus, investing in one share of a company entailed unlimited potential losses for the investor, and the potential of such losses must have deterred investing in stocks.
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