Farming Out Risk

Professor Roger Farmer* has recommended that governments and central banks issue debt to buy risky assets that the market cannot absorb. Those who own the assets would receive more money and spend it on things that make those without assets wealthier. This would heavily distort the cost of capital for risky investments and lead us down the path to another financial crisis.

Markets, in general, work best when a large number of participants compete with each other and those that do a better job get a proportional reward for their efforts. In financial markets, those who assess the riskiness of an investment better than their peers stand to win. If one large participant dominates the others in size, is not interested primarily in profit and does not have the best strategy or people, the market-clearing prices will almost surely be distorted.

In an FT article (31 March 2013), Prof. Farmer argued that “for markets to work well, everybody who has an interest in the outcome of volatility must be able to trade in those markets.” This point ignores the fact that to trade in those markets, people have to understand what they are buying and selling and what the price means. Since doing so is time consuming and can push the limits of mental capacities, we have developed a system where we employ people to trade on our behalf. Pension funds and mutual funds manage money on behalf of a large proportion of the population; the model works substantially better than a centrally planned scheme or one where everyone has to make his or her own decisions.

Governments already provide a social safety net that reduces the risk of being exposed to financial crises. But arguing that there is a need to supplement this by distorting the cost of capital will only have short-terms benefits and ultimately will help those that are already wealthy to a greater extent.

Prof. Farmer contends that future generations may suffer if they inherit a weaker economic system, especially one caused by a financial crisis. No one would take issue with the idea that those born in the 1960s have done better (economically speaking) on average than those born in the 1920s or indeed in 1990s. But, asking a government to manipulate the price of financial securities is not the way to equate this injustice. Not everything that can have a bad outcome needs to be managed to avert that outcome – see Taleb’s Black Swan of Cairo piece for an excellent exposition of this.

In a capitalist system, governments are charged with facilitating the pricing mechanism and stepping in when markets fail to do so – textbook examples include excessive pollution and collusion. But, especially at a time when economies are creaking under the weight of debt burdens, there is a very strong case to say that governments should be careful in what private activities they choose to interrupt.

* Roger E. A. Farmer is Distinguished Professor of Economics at UCLA and Senior Hublon Norman Fellow at the Bank of England

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2 thoughts on “Farming Out Risk

  1. “In an FT article (31 March 2013), Prof. Farmer argued that “for markets to work well, everybody who has an interest in the outcome of volatility must be able to trade in those markets.” This point ignores the fact that to trade in those markets, people have to understand what they are buying and selling and what the price means.”

    There is an entire class of investors, namely everyone who will be born, or achieve the age of majority, in the next twenty years, who cannot hire a pension fund manager to trade on their behalf. They do not exist yet. This is a serious market incompleteness that explains why private markets misallocate capital.

    Reply
  2. Thanks for the comment. I would make two points in response: (1) governments would not be able to manage the risk on behalf of this class of investor efficiently or effectively and (2) the job of the fund manager is to price the risk of future claims on the cash flow produced by various entities and doing so properly (at the aggregate level) will mean that future generations will inherit well-priced securities; they should therefore have no reason to feel aggrieved. This is an interesting debate that I think does not get enough attention, perhaps because, like you’ve said, those that it matters most do not have a voice.

    Reply

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