The Risk-Reward Tradeoff

Al asks a good question in the comments (well, he presents it as a statement of fact, but I will take it as a question): Is increased risk just the flipside of the increased returns of our economy? Don’t we have to take risks to achieve rewards, and won’t providing security prevent that?

Al’s not the only one making this point. Both Brink Lindsay in his review of my book in the Wall Street Journal, and Tyler Cowen, in his otherwise favorable assessment of my book on “marginal revolution,” suggest that I understate the gains that have come with increased risks. So is economic security just an inconvenient but necessary byproduct of our economic success?

The answer, I am convinced, is no. In fact, quite the opposite: We could increase the gains of our economy–and make them more fairly distributed–by providing basic financial security.

Let’s start with the first simple point, one that Kevin has been drumming away at (sorry for the pun) for years: It’s not as if middle class Americans are making out like bandits in the American economy. The statistics are pretty clear. Median-income Americans have seen only modest growth in their incomes over the past generation; most of the gains have been at the top. Plus, most of the gains at the middle have been due to the increasing work hours of families (specifically, the increasing work hours of women). I think the movement of women into the workforce is something to celebrate, but it can’t be described as a great victory for the middle class that families have gotten ahead only because they’ve worked more.

This is when the risk-return folks turn to other arguments. They say that upward social mobility has increased (it hasn’t). Or they say, as Cowen and Lindsay do, that Americans are living longer (true, but it’s hard to argue that this is a result of us facing more risk–after all, people live even longer in many European countries with generous welfare states–or that it makes the increased economic insecurity families face irrelevant, or that it should make us less concerned about the rising number of Americans without health coverage). Or, to pull out the ace card that Lindsay finally resorts to in his rebuttal, they say that income inequality has increased, but inequality of consumption — what people spend — hasn’t.

What should we make of this claim? Well, first, it’s probably wrong. Consumption inequality is less than income inequality, but it seems to have increased just as much. But the broader implication is that we shouldn’t worry about drops in income because people can deal with these drops on their own — hence their consumption is less unequal than their incomes.

But how are people dealing with these drops on their own today? Mostly by going into debt. As I show in my book, median household debt as a share of income for married parents was more than 125 percent of income in 2004. The economist Herb Stein once said, “If something can’t go on, it won’t.” And the debt hemorrhage of the American family simply can’t go on.

If the returns of rising risk add up to the ability to borrow more to dig oneself out of short-term holes (thus digging a deeper long-term hole), then I think we can safely say that most Americans would be happy to give up the returns to obtain greater security.

But here’s the kicker: We can provide security and help our economy. Just as businessmen and entrepreneurs are protected against the most severe economic risks they face to encourage economic investment and growth, we are most capable of fully participating in our economy, most capable of taking risks and looking toward our future, when we have a basic foundation of financial security. Economic security is not opposed to economic opportunity; it is its cornerstone. And restoring a measure of economic security in the United States today is the key to transforming the nation?s great wealth and productivity into an engine for broad-based prosperity and opportunity in an ever more uncertain economic world.

How do we do that? That’s the subject of my next post.