Risk Markets And Politics

Monday, September 19, 2005

Timely Mediations

Since Katrina, an increasing number of pundits and politicos are writing the epitaph on small government. This became clear even as the fiasco unfolded, and the drumbeat is still growing. Although legislation-linked futures markets appear to be on the side of Libertarianism and minarchism, ultimately they will be attractive to both the Left and Right — to both progressives and various sorts of conservatives.

Before suggesting some new examples of LLFMs, I'll say a word in defense of minarchism. It's obvious that while this administration touts small government, in the realm of doing it has actually created a fiscal mess of historic proportions — but their lack of competence (or what have you) is not in itself an argument against small government policy. I fear that the growing frustrations and ad-hominem obsessions of the Left are causing progressives to confuse ideas with people. Consequently, babies are in danger of being thrown out with bathwater. Now, I will not specifically defend "supply-side" economics. (It is potentially subjective whether you are on the right or left of the Laffer curve maximum, and correct supply-side policy only cuts taxes when you are on the right side of the maximum. Likewise, the results of such policies are difficult to prove since experimental controls are lacking. Perhaps tax receipts increase but would have actually increased more without the cuts. Perhaps any economic growth subsequent to implementation is a result of other liquidity factors such as interest rates.) Nonetheless, I don't think the basic insight of the Austrians is at all in question: that decision-making is better distributed to the many individuals who are affected by the decision(s), rather than entrusted to a distant, semi-interested authority possessing vastly less knowledge. The latter situation will inevitably result in more shortages and gluts, even if incentives are not a problem.

I am however a utilitarian first and a minarchist second. Economic efficiency is a mean to general happiness, not an end in and of itself. Now you can certainly compile a list of problems with strict Utilitarianism as we did in our undergrad philosophy classes, but I will just say that I am not an absolute Utilitarian, and I think that will suffice here. Critics of small government thinking must be careful not to mistake ideas for people and bad examples; proponents must take care to not mistake means for ends.

To me, the question posed by Katrina is not so much a general problem of big vs. small government, but more importantly, of effective government. To a large extent, the size question applies to the government's role with respect to many types of insurance, disaster relief being one of them. Which sorts of insurance should have compulsory payments and/or universal coverage, if any? How does insurance differ from infrastructure, like police, roads and courts? Those are clear, specific versions of the question.

In terms of risk-sharing, many of our practices will someday be looked back on as medieval medicine is now regarded. Advances in communication have made it possible to quickly share risk with low transaction costs in a many-to-many manner, but this is just being dimly realized, especially where politics are involved. In addition to more traditional forms of private and public insurance, I have here introduced the concepts of tax and subsidy insurance. People should be able to hedge against their taxes, and every piece of tax and subsidy legislation can be described in terms of its "implied tax effect" on every taxpayer. (This framing alone encourages fiscal responsibility.) With subsidies, legislation-linked futures markets would allow two types of hedging/insurance to occur: 1) the potential recipient could sell futures representing the probability of receiving the subsidy, and 2) every other taxpayer could buy the probability of passage, thus hedging against their implied tax loss if the subsidy is granted.

Furthermore, legislators should welcome these markets as they will help to dissolve political log-jams by allowing private entities to meet each other "half-way" through their hedging. "Pork" will be a lot less painful to cut from budgets — and there is plenty of pork still out there despite what some people say. Democrats should attack on this point and Republicans should co-opt them, retaining the better parts of their small government thinking. Legislation-linked futures markets would help to unwind all these questionable subsidies and put a dent in the spending side of the creeping fiscal crisis.

Monday, September 05, 2005

The Changeling

Legislation-linked futures are likely to first make their mark functioning as tax and subsidy insurance. That is, these futures will be used by parties to hedge against the impact of tax and subsidy legislation.

Consider the estate tax repeal bill (H.R.8 / S.420). It is estimated that the permanent repeal of the tax would cost the government $70 billion per year starting in 2011. Even if this estimate is high, there is certainly room for a significant market to develop here, spurred by individuals seeking to lock-in a certain after-tax estate size. (Of course, this is contingent on whether LLFMs gain the blessing of the CFTC and to an important, but lesser extent, whether the specific contracts are deemed to fall under IRC ยง1256(e)(2) and are officially recognized as hedging instruments.)

As it turns out, Katrina has derailed proponents of the repeal for the time being, and this effect should have more traction than market interest rate moves seen last week in response to the disaster. Republican leadership should surmise that it will be infeasible to pursue tax breaks affecting wealthy heirs when there are scenes like this in the newspaper: "But the bodies are everywhere: hidden in attics, floating in the ruined city, crumpled in wheelchairs, abandoned on highways."

Meanwhile, progressives are seizing on Grover Norquist's stated goal of cutting government down to the size "where we can drown it in the bathtub", citing the disaster as a strike against minarchism (small government). Libertarians, et al answer that the flooding situation in New Orleans and the extent of its aftermath was precisely a failure of government. Is there a more constructive way to frame the debate? The focus here should be on making government more efficient by fostering new structures of public and private organization — which is the philosophical basis of legislation-linked futures markets. The key is for legislators to see LLFMs not as a subversion of their powers, but as means to ease political log-jams and get things done. When LLFMs are used with tax and subsidy legislation, this creates an environment where it is much more likely that political opponents will meet half-way. With LLFMs, issues in fact become partially de-politicized as decision-making is distributed to the private sector. Government becomes more efficient as a result.