Opinion

Felix Salmon

How insurance improves living standards

By Felix Salmon
July 29, 2011

It comes as no surprise to find that Alan Greenspan is wrong. But with respect to his latest column, an attempted defense of laissez-faire regulatory policies and lower bank capital standards, it’s worth explaining in a little detail exactly why he’s wrong.

Greenspan’s thesis does have a certain internal logic:

Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.

But if you think for a moment about the logical implications of what Greenspan is saying here, they’re truly horrific. Imagine a world where the Japanese government did not insure its population against extremely low probability events like the recent earthquake — this is Greenspan’s example, not mine. The toll of death and suffering in one of the richest countries in the world, which was catastrophically high to begin with, would soar, and the Japanese government, through inaction, would be killing thousands of its own citizens, in a heartless and entirely avoidable decision. Meanwhile, the broader Japanese economy would suffer much more greatly than it already is.

In other words, the Japanese government doesn’t need to be “pressed” to save its citizens’ lives in the event of a disaster; that’s its job.

What’s more, the second part of Greenspan’s thesis is equally incoherent, if not quite as morally monstrous. According to Greenspan, things like “expensive building materials whose earthquake flexibility is needed for only a minute or two every century” are “idle resources” and therefore in economic terms a waste of money. But a significant part of the Japanese economy is comprised of companies and individuals engaged in manufacturing and installing precisely those expensive building materials. It’s hard to see how the production of goods and services means that the economy is not engaged in the production of goods and services.

And it’s simply not true that the insurance industry acts as a brake on the economy, an area where otherwise-productive resources go to be wasted and squandered. Indeed, there’s a strong case to be made that when we remit our insurance premiums to someone like Berkshire Hathaway, they’re invested rather better than if they remained sitting in our checking account.

But all of this is just throat-clearing, really: Greenspan’s using his awful Japan metaphor to try to persuade us that banks shouldn’t be regulated, and that their minimum capital levels shouldn’t be raised in the wake of the financial crisis. If only capital levels hadn’t been raised, says Greenspan, then the banks could be lending out that money instead!

Except, there’s no indication whatsoever that banks have any particular appetite to lend out more money in the present economic climate than they’re doing already. And as my commenter dWj says, if banks have more capital, that really doesn’t slow down the economy one iota:

If the Fed prints $5 trillion of new money and puts it in a hole in the ground, it has no impact on the economy (unless it somehow influences expectations). If the Fed doesn’t print $10 billion of new money but someone puts $10 billion in a hole in the ground (or generally takes it out of circulation for many years), that’s contractionary. Extra equity for banks held in the form of dollars — I assume they wouldn’t hold it in piles of factories or mining equipment — doesn’t tie up real resources, and would presumably be counteracted by the Fed in terms of its nominal effects; it would only make a difference if people expected it to actually enter circulation, i.e. if banks were expected to start crashing, i.e. exactly when you want people to expect looser monetary policy.

I support bank capital requirements to stabilize the financial system, but if you want to support them as an automatic monetary stabilizer, that’s okay, too.

To put this another way, the stated aim of high bank capital requirements is that it will help prevent banking collapses. That’s a good idea, even if Greenspan doesn’t seem very impressed. But there’s another way that high bank capital requirements can help the economy. They start being used when the economy is in crisis — which is exactly the point at which you want a bunch more money in the system. It’s like an automated sluice in a reservoir, which rises when the river gets too low.

Meanwhile, so long as bank capital is just sitting in the form of idle money at the Fed, it’s doing no harm to the economy at all, and if the Fed wants more money in the economy, then the Fed can orchestrate precisely that. The Fed’s in charge of monetary policy, after all. As one would expect Alan Greenspan, of all people, to know.

While Greenspan says, then, that we’re suffering from “an excess of buffers at the expense of our standards of living”, he adduces no good reason at all to believe that buffers actually reduce our standard of living in the slightest. In fact, the opposite is true — ask anybody who has experienced both wealth and poverty. When you’re wealthy — when you have a nice capital buffer to absorb mistakes — you don’t worry so much about running risks, and you’re significantly happier than when you’re poor and you have to be much more worried about where your money might end up. Insurance improves living standards, it doesn’t detract from them. Let’s have more of it.

Comments
14 comments so far | RSS Comments RSS

There is so much wrong with Greenspan’s column, I’m impressed you were able to hold your critique under 1,000 words.
I’d just add that the inadequate capital in place in 2008 has depressed living standards worldwide for the past three years and looks poised to do so for the next decade and more.

Posted by RZ0 | Report as abusive
 

Why does anyone publish Greenspan?

Posted by MarkWolfinger | Report as abusive
 

Greenspan annoys me. If you read between the lines, he’s trying to protect his own actions that led up to the housing and credit bubble, by suggesting that deregulation (the insurance and buffer against black swan events) is unnecessary because it is wasteful.

And anyway, he decontextualizes the Great Tohoku Earthquake for his own benefit. Haiti’s most devastating earthquake was a 7.0M. For them, a 7.0 was a low-probability, highly destructive event. But Japan had long created assurances in the forms of insurance, building and zoning codes. For them, it was a 9.0 that became a low-probability, highly destructive event. But what if they hadn’t bothered to create buffers?

2003 05 26 – 7.0 (M)
2003 09 25 – 8.3
2003 10 31 – 7.0
2004 09 05 – 7.2
2004 09 05 – 7.4
2004 11 28 – 7.0
2005 08 16 – 7.2
2005 11 14 – 7.0
2009 08 09 – 7.1
2011 03 11 – 9.0

Crazy Greenspan.

Posted by GRRR | Report as abusive
 

Greenspan’s idea of “idle resources” is so disconnected from reality it’s scary. And there’s absolutely nothing economic about his thinking. It’s pure libertarian twaddle.

Following this logic one could get themselves killed in so many interesting ways. Other wastes of money: seat belts, helmets, condoms, and on and on. Especially condoms. Only something like 0.5% of the worlds population has AIDS. Condoms are a waste of money!

But on the serious side, there has to be some interesting parallels between the current assault on regulations and the fight over safety regulations with the automobile industry.

Posted by LeroyDumonde | Report as abusive
 

Not that I agree with Greenspan, but you can’t dismiss his point about insurance out of hand. Resources used to insure against once-in-a-century events have an opportunity cost, like everything else. It’s not outside the realm of possibility that more lives could be saved by using that money in healthcare, or to replace coal power plants. The traumatic and media-attention-heavy nature of these rare events does suggest that there will be an over-allocation of resources toward insurance against them.

Posted by a.soffronow | Report as abusive
 

It’s also useful to note Martin Wolf’s comment on/below Greenspan’s article: “Bank capital is lent. Mr Greenspan seems to be confusing the two sides of the balance sheet. Equity capital is just another way of funding lending.”

Posted by Kamekon | Report as abusive
 

I do think that some of Greenspan’s article can be read simply as making the reasonable point that insurance does have a cost, and that it would be possible to buy more than we want for the price it costs. When he asserts that we do buy more than we want, he should include evidence to that effect.

As for the part of the Japanese economy that comprises “companies and individuals engaged in manufacturing and installing precisely those expensive building materials”, the question is what those individuals would be doing if they weren’t in that business. There is on some level a broken-windows fallacy here, played out in advance; in particular, suppose we knew for certain that this was it for Japan and earthquakes for the next 200 years — they just filled their quota — in which case we know that it’s a waste of real economic resources to continue to use more expensive materials than necessary. That nobody believes Japan has run out of earthquakes means that there is value in using those materials, but does not mean that this is no longer a cost; it is simply one to be weighed against real benefits.

Posted by dWj | Report as abusive
 

DWJ said: “I do think that some of Greenspan’s article can be read simply as making the reasonable point that insurance does have a cost, and that it would be possible to buy more than we want for the price it costs. ”

While that is the premise of the article, he is trying to rewrite history and have us make his hand in the pie, invisible. He can’t be the hero in the Fountainhead if we all believe he is fallible and regulations he fought so rigourously to end, skewed, softened or not be implemented at all, are necessary.

As he ages he wants his legacy to fit his fantasies. Self-preservation isn’t just for the market, so he will be back with more analogies.

Posted by hsvkitty | Report as abusive
 

What’s the difference between “idle resources” and “adequate capital reserves”? Curious that Greenspan can criticize one while recognizing the need for the other. Ahh… the divided mind!

Greenspan seems not to understand that the devastation of a tsunami or hurricane are acts of nature. The collapse of the global economy is the result of the failures of men. His strong defense of the failed ideology that led us to the economic crisis ensures that his legacy will be one of blindness and failure.

Posted by MainStreetMuse | Report as abusive
 

Think about this in model terms. The economic models he has built into his brain have great trouble accepting demand side issues. They are essentially supply oriented models coming in the Ricardian heritage. All the stuff he’s written has been a variation that them: business lacks confidence, business resources are engaged by government restriction. This is the only way it makes sense to him because he can’t grasp – and neither can many others – that their models aren’t working because they’re woefully incomplete. It’s very difficult to accept that fundamental a blast to one’s intellect. Greenspan and these other try to breathe life into their models by finding impediments to supply. These can be expectations of future tax increases or future regulation or reductions in overall risk taking (which isn’t even lending for banks, but involves their trading activities). It’s utter nonsense, but their world view is under pressure so they are doubling down on what they believe.

Posted by jomiku | Report as abusive
 

It’s fair to assume that the caricature presented above in chopped-up context-less quotes does not accurately represent Alan Greenspan’s conclusions, or the arguments he uses to support them. Which calls into question Salmon’s honesty, and makes his post worse than worthless.

Posted by QuixCap | Report as abusive
 

Poor quixcap. Not only lacking in the ability to read and think critically, but also unable to hone his skills as a troll well enough to mask his fundamental illogic.

Posted by lauradeen | Report as abusive
 

Not trusting anything Greenspan or anyone from the FED says.

Clearly, we need to question not only whether to insure (which probably should be answered yes),

but also who insures (and that should probably be answered NOT the FED, NOT the government).

Why? Too much waste, too much incompetence.

Posted by sherryk | Report as abusive
 

“If only capital levels hadn’t been raised, says Greenspan, then the banks could be lending out that money instead!”
I think both Greenspan and you fall into the Jimmy Stewart school of banking – everything would be OK if only banks lent. Lending only works if you get paid back with interest and some profit.
http://research.stlouisfed.org/fred2/ser ies/MULT

Posted by fresnodan | Report as abusive
 

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