Is this as good as it gets? How much can social risk ever decline?

Karl Smith reports:

Are we so sure there is a better way?

Real interest have famously been on the decline for thirty years. A rougher historical record suggests that English real interest rates may have been in decline since at least 1600.

The standard explanation here is better governance and lower systemic risk.

Yet, lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.

Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have larger been successful. As a result our lives are getting more and more stable.

As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.

When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.

So, putting it all back together and we come up with something of a risk floor, if you will.

Policy makers drive down systemic background risk. This makes everyone safer. In response, each individual takes on a little more personal risk and contributes slightly to the general background risk.

Eventually we will reach a point where policy makers have driven out so much systemic background risk that any marginal decrease systemic background risk will simply induce individuals to take on more personal risk until they raise the total risk level back up to where it was before.

Safer policy then has little net effect.

Said another way, attempts to prevent bubbles from forming will only make folks more complacent about bubbles. Eventually, a bubble will slip through the cracks. However, folks will deny it’s a bubble, because don’t you know, bubbles are a thing of the past. Even as it grows to massive proportions the smartest minds will argue that it only looks like a bubble. If it were a real bubble, surely the Fed would have popped it by know.

And, so it grows larger and larger and larger. When it pops the downdraft is so great that policy makers don’t have the tools to deal with it. Perhaps, in a technical sense they do. They could stand firm on an NGDP target or pass the mother of all stimulus bills.

However, emotionally they are at a loss. They have never seen anything like this and until recently thought it was impossible. Now, they are being asked to approve policies that no one has used since the dark ages, while in the middle of a crisis no living person understands.

This is a task few people have the nerve to handle. And, so they don’t handle it and the downdraft smashes the entire global economy to bits.

Such, is often the problem of “over-solving” the problems of the past.