In a real sense, human history starts with the creation of a social surplus, a surplus beyond simple subsistence. Such a surplus could be used for–indeed, was required to–build more complex societies. This included the literal building of the monumental architecture, the most striking creations from the existence of such surpluses.
More food, more babies
Merely increasing production does not mean there will be a social surplus. The normal tendency has been for population growth to increase to consume the food production available; given that the best way to manage farming and ageing was to have children. This Malthusian constraint continued to operate in human societies until quite recently–the history of China from 1700-1850 is a classic example of increased food production leading to population increasing faster than food production leading to a massive breakdown in social order (one of the deadlier such in history) with the loss of state revenue and diversion of resources to warfare undermining basic management of resources.
As I noted in a previous post, it is highly plausible that expropriating elites were what originally created the social surpluses enabling the building of more complex societies. For much of human history, it was obvious what was the dominant way to get access to social surplus: political power—either having it or serving it. Control of the means of coercion provided the dominant source of wealth. (And having the backing of the dominant coercive apparatus is still pretty useful.) With considerable amounts of said surplus being invested in the priests who helped manage both social complexity and expropriation by providing rituals of belonging; norm-advocacy; narratives of meaning, explanation and rationalisation; various services (calendar management, doctors of body and mind, teachers, engineers, scribes, mediators); plus formalised signals of commitment to the expropriating rulers and their social order.
To be sure, there was plenty of trade (and wealth from trade). Nevertheless, extracting surplus from peasants or controlling trade routes (and particularly trade nodes) was much the dominant source of wealth: especially inheritable wealth. In many early civilisations, the ruler was the dominant trader. If trade collapsed, that tended to both increase the dominance of wealth-through-violence while making it harder for any particular ruler to (re)establish control over a wide area—due to a lack of sustaining surplus to pay for the necessary extensive control. Collapse of an extensive, trade-managing (and so protecting) rulership often being the main cause of the collapse of trade in the first place.
The more centralised and territorial the generation of surplus is, the more it will attract attempts to seize it (hence the long history of territorial wars). This extends to our own period: having export wealth dominated by easily controlled primary production encourages both autocracy and civil conflict (pdf). Living in a society where wealth-through-the-means-of-violence, where centralised control of surplus, is not dominant is both historically rare and desirable.
It is impossible to achieve mass prosperity without getting out of the Malthusian constraint wherein increased food output merely leads to, and is consumed by, increased population. To put it another way, to evade the Malthusian constraint, the social niches people occupy have to be larger than subsistence. The more such social niches spread down the social scale, the more general prosperity becomes.
Ever since the rise of hierarchical societies, there have been social niches which were larger than subsistence; they were the niches of elites. Indeed, as Peter Turchin points out, one of the perennial problems of hierarchical societies is precisely the size of elite niches. If the elite increases in size faster than output, then competition for elite niches will ensue. That process has been one of the great drivers of history. (For example, the tendency for the ruling clan of pastoralist empires to breed enthusiastically likely helps explain the tendency of such empires to break up after a few generations as too large an elite fights over too few elite niches.)
For elite niches to occur in a society within the Malthusian constraint, a surplus has to be extracted from those lower in the social pyramid. To be on top of a social pyramid is to be on top of a process of surplus extraction. A process which continues in post-Malthusian societies. This is obvious enough in developing world kleptocracies (pdf), but is hardly unknown in developed democracies. Jon Corzine (CEO of MF Global, which has just gone bust in one of the largest bankruptcies in US corporate history) is an excellent example of someone living on top of the surplus pyramid:
based on his long years in the financial business, from CEO of Goldman Sachs to his current job as chief executive of the failing MF Global, Corzine is proof positive that on Wall Street you don’t have to be very good at your job to get paid a lot of money, which is why hatred of fat cats remains a bipartisan pastime—and will for the foreseeable future.
Pushing risk downwards
A standard way to live on top of the surplus pyramid is to push risk down the social pyramid. At its most brutal, it involves pushing the risk of starving downwards. But it can happen even in societies which have escaped the Malthusian trap. Consider this comment by the Rt Hon. Vince Cable MP, UK Secretary of State for Business, Innovation and Skills in a generally excellent speech about parallels from the 1930s for our times:
It is worth recalling just how brutal were the first dozen years after the First World War. Britain attempted to return to its pre War gold level, which meant chronic deflation to bring us back with world prices (what Southern Europe is attempting today). As a result, the price index which had risen from 100 in 1914 to 250 in 1920, fell to 180 in a couple of years and continued falling all the way below 150 in 1930.
The voices in the City clamouring for the Pound to be kept strong got what they wished.
But the consequences for the real economy were devastating; production fell by 22% between 1918 and 1921. The real value of debts rose and rose. The exchange rate was far too high and so our goods struggled on world markets. On some measures in 1931, our per capita GDP was lower than it had been in 1915.
No wonder Churchill made his lament about wanting industry more content, finance less proud.
That was pushing risk downwards with a vengeance.
Let us consider what “too big to fail” means. It means someone who borrows too much to buy a house can go bankrupt, but the institution which lent too many such people too much money cannot. It is a classic example of pushing risk downwards.
It is also a profound subversion of commercial society, which Milton Friedman liked to point out was a profit and loss system:
You must realize that what we have is not a profit system; it’s a profit and loss system. The loss part is just as important as the profit part. What distinguishes the private system from a government socialist system is the loss part. If an entrepreneur’s project doesn’t work, he closes it down. If it had been a government project, it would have been expanded, because there is not the discipline of the profit and loss element. If you have a really good idea, it may work. But remember, you’re gambling. That’s what makes it exciting, and that’s what makes it important. What rules out the mistakes is the possibility of making a loss.
To put it another way, any social system generates “barnacles”–resource-consuming social nodes that undermine the overall operation of the society. It is undermining or lacking a barnacle-removing process which is fatal to a social system.
But it can be very attractive to be a social barnacle. To be insulated from loss is a massive and corrupting privilege. To be insulated from loss while being massively paid for managing risk is offensive exploitation of the weaker.
What happens when the IMF moves in to do “structural adjustment” when a developing country has got into trouble from debt loaded on the polity but skimmed off within its elite? The risks are pushed downward. Debts which were allegedly to increase productive capacity get expropriated. The people best placed to assess the likelihood of that bear little or no risk from it (due to the IMF), so the risk gets loaded on to those who were not there (nor seriously represented) when the debts were negotiated and have little or no capacity to object or block expropriation. So the debt is loaded onto the ordinary folk of that society, but those who stole it get away with it and those who lent to those who stole it have the impact on them minimised. (The UN Convention Against Corruption [UNCAC]‘s asset recovery provisions represent, in effect, a regulatory attempt to deal with the problem of corruption–including to block debt diversion by kleptocratic elites–and none too soon.)
Forcing ordinary taxpayers to repay stolen debt is a fairly vile worship at the altar of financier privilege. The notion that the claims of high finance are so much more important than any other consideration. Claims whereby huge salaries and bonuses are paid, justified by management of risk which is pushed off on to taxpayers and those lacking such political clout. Which, as the UK experience in the 1920s showed, can be entire industries and workforces.
There is a kernel of truth in the claims of high finance. It is important that credit keep flowing. If the flow of funds completely freezes up, massive economic harm can be done.
But, and it is a very big but, the point of supplying that credit is to manage effort across time and the risks thereof. The point is to allocate the risks to those best able to manage them, not those least able to avoid them. If those lending funds to developing world rulers are not taking any responsibility for monitoring whether those funds are likely to be spent in way which will increase the capacity of the polity to pay back the loan, they are acting in a way strikingly different from how someone getting a mortgage or a business loan is typically treated. There, your capacity to pay, the use of the loan, matters a great deal; the asset is managed in a more typical commercial style. Hence UNCAC attempting to deal with what financiers have consistently refused to take responsibility for.
Of course, the rise of complex derivatives in the US mortgage market meant lenders were not doing that traditional role of carefully assessing use. But the model of not paying attention to the realities of use of the loan was already established in the sovereign debt market. With a similar justification in both cases–taxpayers would always be available to pay it back, house prices would continue to rise, so systematic downside risk was insignificant.
[If developing countries take on debt that is stolen, spent on patronage or simply poorly invested, the debt increases, not decreases, their economic and financial vulnerability. The contrast with ordinary business and household debt is marked--a loan which was likely not to improve the capacity to pay the loan back, whose only likely effect was to increase the financial vulnerability of the borrower, would not be regarded as a good commercial risk. Loans which increased vulnerability were also a feature of US mortgage markets, making the similarities between the corrupted public debt market and the corrupted US mortgage market even clearer.]
Anything which systematically shields agents only from downside risk increases instability in the system. (And do so even if they only believe they are shielded from such–see any asset bubble of your choice.)
If risk-managing firms move from being (pdf) full-liability partnerships to limited liability corporations, that shields the actual managers of risk from downside risks. If the state makes deposit insurance compulsory, or otherwise guarantees deposits, that shields managers of risk from downside risks.
Such shielding of agents from downside risk tends to increase the private return to risk management while increasing the social costs. The obvious way to correct such systematic imbalance in downside exposure to risk is to have compensating prudential regulation. The argument for full deregulation of prudential regulation rests on firms as decision-agents-bearing-risks, but modern corporations separate risk and decision-making, leading to perennial corporate governance problems. It is actually rather foolish to analyse firms’ risk management without paying attention to their internal structures, since what institutional incentives exist will clearly affect patterns of behaviour.
There are wider grounds for prudential regulation of financial institutions, due to such considerations as herd behaviour in highly liquid markets being a rational response to limited attention resouces and to uncertainty. Uncertainty, information limitations, fluidity and the existence of financial assets meaning that demand is not an immediate function of supply (of non-competing products, to state Say’s Law [pdf] correctly)–since transacting can be deferred, leading to the “general gluts”/transaction crashes we call recessions and depressions–all make financial markets crisis-prone and crisis-generating.
Too big to fail is just an invitation to fail bigger (pdf). Unless there is compensating prudential regulation. For anything which systematically shields agents from downside risk increases instability in the system.
The great fraud of the current global financial system is that quantifying risk largely eliminates it—if you are managing enough of it.
Worse, to be shielded from consequences is to be shielded from responsibility. To be shielded from responsibility fundamentally undermines moral constraints. It is, in a quite direct sense, morally corrupting. In the sense, and for the reasons, that Lord Acton meant.
If a system of financier privilege is corrupt at its core, it is hardly surprising if it generates even more blatant signs of moral corruption. Such as the Barclays Bank scandal where it systematically lied to manipulate market information, leading to scathing comments from the Governor of the Bank of England. Barclay’s corrupted social processes in quite a direct fashion, a society and economy those engaged in the corruption of are premier beneficiaries of (particularly its information flows). In the words of Lord Turner, Chair of of the Financial Services Authority:
There is a degree of cynicism and greed that is quite shocking. I think we would be fooling ourselves if we thought that some of the behaviour and culture evidenced in Libor fixing are not found in some other areas of trading activity as well.
Possibly it is shocking, but it is only surprising if you have not been paying attention to the incentives being created in financial markets for some decades now. (You can call it blowback, if you like.)
States and risk
If prudential regulation is an appropriate response to both the inherent features of financial markets and the provision of state-guarantees for deposits, then we are, yet again, confronting the paradox of rulership–that we need rulership to protect us from social predators but rulership is the most potentially dangerous form of social predator. For no institution separates decision-making and risk as thoroughly as rulership. Hence voting is a way of connecting risks facing citizenry to risks facing rulers. Alas, it is far from a perfect way of doing so. To paraphrase Winston Churchill, it is the worst way of doing so; except for all the others that have been tried from time to time.
Examining the means by which financial markets have been corrupted, the operation of state power is laced through it. Whether it is the IMF loading stolen loans onto ordinary taxpayers, kleptocratic rulers, provision of implicit or explicit government guarantees, or the bailing out of failed financial institutions, states and their agencies have been major players in the destruction of prudence and so in the corrupting of finance.
The obvious political advantage for sitting on top of the surplus pyramid is in having plenty of surplus to throw around, including into political donations. It is not high finance’s only political advantage, however. The apparent complexity (and so obscurity) of what they do helps shield them from accountability while finance’s very crisis-generating capacity gives them the weapon of fear.
Which creates a perverse incentive structure–the more the finance industry can shield its decision-makers from downside risks, the greater the private return to risk-management but also the greater the social costs and so the more they are able to wield the weapon of fear to shield its decision-makers from downside risks.
While the evidence that political spending significantly influences results of election campaigns (or votes in legislatures) is limited, donations do buy political access. Which is clearly enough.
The first stage in dealing with a problem is acknowledging it. Markets–the operation of a profit and loss system–and voting–the imposing of “throw the rascals out” responsibility on rulers–are our barnacle-removing systems. Unless and until their interacting dysfunction is untangled, any apparent improvement will only be temporary. An industry whose central role is risk-management has become one where the management of risk is profoundly corrupted. Unless that is understood, and the implications grasped, we are set to continue to have a spiral of rising instability and ever-greater financial crises.
 Australia’s four pillars policy represents partial protection of the major banks with a trade-off of strong prudential regulation; the above analysis probably has limited application to Australia.
 Political competition is a rather limited Hayekian discovery procedure (pdf), for example.
 In the case of US Presidential elections, how much the campaigns themselves matter for the election results is something of an open question.
 Political donations are basically a measure of how important political access is to an industry. Hence the largest donors by industry in the US are finance, insurance and real estate (the former two industries need politicians to protect their outsized incomes by continuing to shield them from downside risks and the last operate in highly regulated land-use markets–indeed, one reason to regulate land use is to generate political funding).