How insurance improves living standards

July 29, 2011
Alan Greenspan is wrong.  

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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.


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