Gillian Tett, always worth reading on financial matters, explains that the “rogue trader” problem at UBS is the tip of an iceberg of potential problems around exchange traded funds: “On paper, ETFs (just like CDOs) look like a wonderful idea; they are vehicles that enable investors to gain exposure easily to a diverse range of different asset classes, without having to pay the ridiculously high fees demanded by the active fund management industry – or engage in stock picking, say, on their own.”
What’s striking to me is the extent to which financial markets have been trying and failing to reinvent the wheel here. In life, there’s always risk. But suppose you just have faith in the basic principle that the United States of America as a whole will be richer in 2061 than it is in 2011, in just the same way that every previous 50-year span of American history has featured increased prosperity. Well the best possible way to take advantage of this is to live in a country where able-bodied working age people have jobs and pay taxes, while the elderly, the sick, and the disabled receive benefits. In other words, social insurance. Social insurance isn’t a magic trick that enables society to afford unlimited benefits. But the limits that exist are simply the limits of the economy as a whole. You are fully diversified. It’s possible, of course, for a particular investment to do better than the economy as a whole but if that’s the situation you’re in, you’re carrying extra risk. If you think you’re not carrying extra risk, what you’re doing is carrying tail risk that you don’t understand. Things look different if you’re talking about a very small country. Slovakia is exposed to a lot of idiosyncratic Slovakia risk. But the American economy is itself a diverse range of different asset classes, and the federal government is able to collect taxes and cut checks with very little administrative overhead.
The ideal we should be working toward is one in which average everyday people have their basic need for income security met through a comprehensive social insurance system. If rich people who have the ability to bear extra risk, or middle class people who enjoy gambling, want to go over and above that and undertake risky investments so much the better for them. What we’ve done instead, however, is first shunt extra risk onto households and then pretended that the financial system has the ability to engineer the risks away. That’s created massive incentives for risk-hiding, and massive hidden risks.