The Government And Risk: A Love-Hate Relationship

By Ken Clark AAA

Thanks to the assorted economic crises of the last few decades, the American public finds itself smack dab in the middle of a debate over the government's role in subsidizing risk. The argument centers on what place, if any, the government has in helping individuals and businesses to prosper by guaranteeing that certain industries cannot fail financially.

Many would argue that if it weren't for the government absorbing some of the risk of loaning money, depositing money at banks and producing automobiles or other goods, many industries would grind to a halt. Still, others would argue that because the government absorbs the risk instead of letting these industries collapse when necessary, the nation is put in a position of a catastrophic overextension of its limited finances. (Read more in Is The U.S. Government Too Big To Fail?)

Hence, the American public now finds itself between a rock and a hard place when it comes to picking a side. On one hand, many people's jobs, mortgages and student loans are seemingly dependent on this government backing of certain industries. On the other hand, the spiraling bailout costs to taxpayers have many fearing that the system is nothing more than a house of cards waiting to collapse under its own weight. Before you form an opinion one way or another, it's crucial to know the mechanics, theory, pros and cons of the implicit government subsidization of risk.

What is Explicit Risk Subsidization?
Many people don't realize how dependent the American economy has become on the government subsidization of risk. This is due in large part to the fact that many people are only familiar with the government's few "explicit" subsidizations of risk, and not the numerous "implicit" guarantees the government provides for other organizations.

Explicit subsidizations of risk are those in which the government has made an official declaration about backing an organization or program with U.S. Treasury funds. The most well-known of these programs is the Federal Deposit Insurance Corporation (FDIC), which protects customer deposits against the collapse of a banking institution. Similar to the FDIC, is the NCUSIF, through which the government backs credit unions in the same way they back banks. Then there's the Government National Mortgage Association (GNMA or Ginnie Mae), which helps create a fluid mortgage market by buying loans from banks and packaging them for resale to the investing public. (U.S. bailouts date all the way back to 1792. Learn how the biggest ones affected the economy, read Top 6 U.S. Government Bailouts.)

Implicit Risk Subsidization
As for the rest of the organizations that frequently make the headlines - corporations like Fannie Mae, Freddie Mac and Sallie Mae - they do not carry an explicit guarantee from Uncle Sam. In other words, even though you hear the government talking about them from time to time, it's not actually obligated to do anything to keep them from failing.

Rather, these Government Sponsored Enterprises (GSEs) carry the implied backing of the U.S. government. That is to say, the government expresses a continued interest in the healthy functioning of these organizations, but does not offer an outright pledge to rescue them - though recent history has shown that they will from time to time.

Why Does the Government Implicitly Subsidize Risk?
There are a number of interrelated theories that surround the government's implied subsidization of risk. Each theory is a double-edged sword, with some people arguing that the theory makes the case for the implied subsidization of risk, while others argue that it goes against it.

The most prominent theory supporting the government's implicit guarantees of numerous agencies and organizations is the "greater good" theory. This basic idea suggests that, though there may be drawbacks to the government removing the risks from certain enterprises and activities, there is an overall gain for society. For example, many would argue that the safety of deposits, reasonable access to credit and continuity of certain industries serves the greater good. Of course, opponents would argue that the greater good is served by leaving markets free to take their course and letting risk be either punished or rewarded. (For a look at this argument in more detail, read Free Markets: What's The Cost?)

It should come as no surprise, with the tax bills from recent government interventions piling up, that more and more Americans have begun to question the constitutional basis for subsidizing the risk of GSEs. At the center of this debate, is the General Welfare Clause (Article I, Section 8) of the Constitution, which gives the government the authority to tax in order to promote the general welfare - a concept that's not too distant from the idea of the greater good. Naturally, many would contend that taxation to support the government subsidization of risk does promote the general welfare by encouraging certain economic activities. Opponents of the government's role with the various GSEs would argue that the higher taxation required to support such intervention directly acts against the general welfare.

Practical Pros and Cons
While the economic theory of the government subsidization of risk is fascinating, most people are ultimately concerned with practical advantages and disadvantages of the government absorbing some of the risk from various economic markets.

There's no doubt that the biggest benefit to most consumers is easier and less costly access to borrowed funds. This is the area in which most consumers would immediately suffer if the implicit guarantees were removed from organizations like Fannie Mae, Freddie Mac and Sallie Mae. (Learn more about what Fannie Mae and Freddie Mac do in our article Fannie Mae And Freddie Mac, Boon Or Boom?)

For example, it seems unrealistic to think that the average 18 year old would still be able to borrow $100,000 to pay for college, if the government did not offer some form of subsidization of risk to student loan lenders. Likewise, if the government did not provide an outlet for the resale of mortgages made to customers (which it does by implicitly guaranteeing the safety of those repackaged investments), no bank would be able to continually lend $200,000 at a time to help families buy homes. Further, those students or homebuyers who were lucky enough to secure loans in such an unsubsidized environment, would likely be charged higher rates to help absorb the losses the government no longer protects against.

While that may make a sufficient case for many when it comes to the government subsidization of risk, it does come with a large practical disadvantage - the ongoing cost to taxpayers. Government subsidization is not free, and the costs will ultimately need to be absorbed somewhere. Of course, when government finances are already stretched to the breaking point, this means that it gets passed on to future taxpayers by adding to the national debt. In a worst-case scenario, with the government stepping up to meet multiple implied obligations at once, a crushing obligation could get transferred to future generations. (For more on the national debt, take a look at What Fuels The National Debt?)

Conclusion: A Love-Hate Relationship
In the end, America has a love-hate relationship with the government's implied subsidization of risk. Consumers love the easy access to affordable credit; Communities enjoy the hundreds of thousands of jobs that these stabilized industries provide. Investors crave the competitive return and relative safety of GSE securities.

But when the bill for all this convenience finally comes, it can produce a major dose of sticker shock. There's no doubt that as Americans grow increasingly educated about the implied subsidization of risk by the government, the topic will work its way to the forefront as a national and political issue.

comments powered by Disqus
Related Articles
  1. What You Need To Know About COBRA Health ...
    Insurance

    What You Need To Know About COBRA Health ...

  2. Can Good News Be A Signal To Sell?
    Fundamental Analysis

    Can Good News Be A Signal To Sell?

  3. Beware Of Wall Street's Three Big Lies
    Fundamental Analysis

    Beware Of Wall Street's Three Big Lies

  4. Changes In Tax Legislation And Regulation
    Taxes

    Changes In Tax Legislation And Regulation

  5. How To Become A Corporate Board Member ...
    Personal Finance

    How To Become A Corporate Board Member ...

Trading Center