Welcome to Known Unknowns, a newsletter that’s here to remind you that although you can shift risk onto someone else, it never really disappears.
Another day, another $3 trillion
There’s an age-old question that has long divided people, as well as made and broke empires: How much risk should the government take on? This question took on greater urgency over the past 100 years as the role of government and risk reduction changed. Capital became more plentiful, we collectively moved to cities, we developed weaker community ties, and faced more systematic risk, so risk reduction within communities necessarily became more difficult. This all became clear during the Great Depression, which is how we got the modern welfare state in which the government took on some of our risk of income loss, old age—and, later, our health. This was efficient in many ways, because the government could diversify risk across individuals and generations. When you shift risk from individuals to the government (or anyone else, as what happens every day in financial markets) one of three things can happen:
1. The risk still exists, but it’s smaller because of the power of diversification.
2. The risk stays the same size and is transferred from one party to another.
3. The risk increases, because you’ve created a new systematic risk, moral hazard, or some distortion in which prices and incentives don’t make sense anymore.
Sometimes there can also be some combination of the three, but this gives us a framework with which to judge new policies, which are often about risk transfer. I think we’ll look back on the post-war era as a Golden Era for risk. Yes, there were some big policy blunders, and more people fell through the safety net than we like to remember. But there was a decent balance of individualism, with some degree of us banding together to reduce each other’s risk through social insurance. It was, on balance, efficient (lots of the first scenario), and we got high growth and increasing living standards as a result.
Now, however, we’re in an altogether new era. Rather than supporting risk and insuring against some downside risk, the government wants to remove it entirely. Or, rather, it seems that no one should ever experience any downside risk (or upside, since they go together) or discomfort. That appears to be the intellectual motivation for the bill that has just passed.
The latest infrastructure proposal goes even further, following the new intellectual (and ahistorical) wisdom that the best innovator is the government. Innovation is inherently risky, and most projects fail. The thinking is that the wisdom of the government can remove risk from the innovation process, or it can handle the risk better than the market can. When the private sector innovates, it’s always a high-risk endeavor, borne by founders and investors who also get lots of upside when it works. When the government is the primary innovator, risk is borne by future taxpayers, and if we end up with wonderful new infrastructure that enhances growth, they benefit. And in the case of the environmental projects in the latest plan, we will also have a cleaner planet. But if this is just a series of boondoggles that waste money, future generations will take all the downside risk by having to deal with our debt. So, unlike social insurance in the 20th century, this is an example of the second scenario more than the first.
But the size and scope of these new bills make me worried about the third scenario. Just like social insurance, if the projects are poorly chosen or poorly structured, new risks arise. This is in fact more likely when the government takes on innovation risk of this scale. Great innovation requires discipline and knowledge of markets. And some fear of loss is what creates that discipline. So, will $3 trillion remake the Green economy of our dreams? Maybe. But the government doesn’t have such a great track record as a primary innovator. The government is better in a supporting role, or in the case of Asian Tigers, implementing market-proven existing technology.
One long-term risk here that we’ve created is diverting resources from their most productive resources and undermining growth and future innovation. If the government selects certain projects on this scale, that’s where the money is, and that’s where the talent and capital go. And that’s a risk, because compared to letting the private sector pick its projects, you now have a smaller group of people making decisions about where the capital goes. If they make a bad choice, we risk bubbles and instability—just look at the price of Tesla, which benefits from government subsidies.
Risks in financial markets
I could be convinced that it’s a worthwhile gamble after all—we may not fully price in the costs of climate change and need some nudging in order to invest in long-term projects that benefit our planet. But this is $3 trillion, the sheer size of which creates many risks in the short and medium term. I keep hearing that the real risk in fiscal spending is doing too little, or if there’s any risk to this spending, it’s just some inflation. But there are many other risks here that get less attention.
One of these is some sort of debt crisis—not a default, but rather some serious dislocations in the financial sector. If you follow macro commentary, you’ll hear that the big risk is inflation. And I agree that that’s a possibility. I’m not too worried about hyperinflation, or even 7 or 8% inflation. But I worry about the volatility, or about inflation becoming less predictable, which can pose more costs than the inflation level.
And I’m even more worried about what all this spending will do to the debt markets. We’ll be issuing a lot of bonds, which I presume will be in the form of short-term debt. The proposed tax increases won’t make a dent in all this spending. And you may have noticed that foreigners aren’t buying up our debt like they used to. For the last year, it has been the Fed stepping up and buying most of the debt instead. So, what happens if they need to start selling bonds instead, if inflation becomes a concern?
We risk higher and more variable interest rates, which creates dislocations in the bond market. Now, if you watch CNBC etc., it’s stocks, stocks, stocks. But short-term treasuries are the most important asset in financial markets. They touch absolutely everything. They are how risky assets are valued, and they determine how much everyone pays for leverage, what the long-term rates will be—you name it, and short-term treasuries are surely involved. Debt is systemic, and it’s not a market that you want to mess with.
So, if the bond market gets wonky, or even just unpredictable, that’s when things go pear-shaped. I’m less worried about runaway inflation than some sort of financial crisis occurring in the next five years or so.
Now, I may be the only debt hawk under 45. But I’m also an amateur economic/financial historian, and what we’re seeing has ended very badly before. And we’ve never tried anything this big and bold.
But hey, maybe it will all work out! There will probably be a big boom this year, and maybe we’ll have a productivity boost that will compensate for all of our sins.
You may have noticed that I moved this newsletter to Substack, though it’s still free. I moved over to the new platform because I like the interface better, it offers more features, and there’s also more visibility. It shouldn’t change anything for you, except maybe I’ll start adding in some graphics. I also get great comments from some of you over email, now you can share them with other readers in the comment section, and I hope you do!
Until next time, Pension Geeks