The Role of Government When All Else Fails

A new book by Harvard Business School professor David A. Moss explores government's under-appreciated role as risk manager in everything from disaster relief to Social Security. How did this role evolve into something today that touches on almost every aspect of economic life?
by Laura Linard

In When All Else Fails: Government as the Ultimate Risk Manager, David A. Moss explores government's role as insurer of last resort in everything from crafting consumer protection law to bailing out airlines after September 11th. He discusses the historical evolution of public risk management in this e-mail interview with Laura Linard.

Linard: You write that a reason to study the historical role of government in risk management is to better "understand government and its role in the new economy." How would you characterize the role of the government in today's and the future economy?

Moss: One of the things that a historical perspective helps make clear is that risk management has always been an essential function of government. From the very earliest days of the American Republic, government policymakers have actively managed risk in the private sector—shifting it from one party to another, spreading it out over large groups, and (in some cases) simply reducing it outright. These policies, in turn, have profoundly shaped the environment in which business operates.

Public risk management itself has obviously evolved and expanded quite considerably over time, such that now—at the dawn of the twenty-first century—it is hard to conceive of any more important or pervasive governmental function. The federal government now devotes a larger part of its budget to social insurance (such as unemployment and old-age insurance) than to anything else, including defense. In several critical sectors of the economy, including banking and private insurance, federal and state governments act as insurers of last resort, assuming literally trillions of dollars in contingent liabilities. Whether you like it or not, the nation's product liability system, which shifts risk from consumers to producers, has dramatically influenced the calculus of production in a large number of industries. Our federal disaster relief policy, meanwhile, has likely affected housing patterns all over the country. In fact, the list just goes on and on. Risk management truly is a critical—and extremely powerful—function of government.

Now, you also asked about the future. One thing I've learned is that historians very often get themselves into trouble when they start trying to predict the future. So I'm not going to try to do that. I do think it's safe to say, however, that this risk management function of government is unlikely to fade away anytime soon.

Q: You argue that risk management is a core function of the American government and that this has been true since the early days of this nation. However, you point out that the active role that government has played in risk management is something that has been rarely analyzed. Why do you think this aspect of the role of government has been ignored?

A: While it is true that risk management has never before been viewed as a function of government, nearly all of the underlying policies (limited liability law, deposit insurance, social insurance, bankruptcy law, disaster relief, and so forth) have been studied extensively on an individual basis. What struck me, however, was that no one had ever looked across these policies and identified what they had in common. Perhaps this is because the goals associated with these policies varied so widely. A policy aimed at strengthening the banking system, for example, might seem to have little in common with a policy designed to compensate the victims of involuntary unemployment. But the truth is that public deposit insurance and public unemployment insurance actually have a great deal in common, since both require participants to spread risk on the basis of an insurance model.

The nation's product liability system, which shifts risk from consumers to producers, has dramatically influenced the calculus of production in a large number of industries.
— David A. Moss

In fact, both of these policies—and many others like them—operate in very similar ways, which is why a comparative perspective is so helpful. Once we understand that a great many seemingly unrelated policies all fit under the rubric of risk management, we can begin to identify some common rules and problems, which makes the policies themselves a whole lot easier to figure out. This is basically what I've tried to do in my book.

Q: You point out that American risk management policy has passed through three phases. Can you give the major characteristics of these phases and what factors marked the transition to the following phase? Would you be able to predict what the fourth phase might be?

A: One thing that I noticed in exploring the history of these risk management policies is that the basic goals policymakers were pursuing changed rather substantially over time. Long ago, back in the nineteenth century, the main objective of most risk management policies—from limited liability to bankruptcy law to a fixed exchange rate—was to encourage trade and investment and thus to facilitate economic growth by making investors and traders feel more secure. I refer to this as Phase I of American risk management policy, which aimed at assuring a more secure environment for business.

By the early twentieth century, however, the focus had shifted, from business to labor. As a result of industrialization, a great many workers had moved from the farm to the city and had become completely dependent on their money wages. Although many workers were now living better than before, many were also less secure, since they could no longer rely on extended family support networks, which were a common feature of farm life. Any interruption in an industrial worker's earning power could prove devastating, whether because of a workplace accident, illness, unemployment, or old age. Government policymakers responded to this rapidly expanding problem of worker insecurity by constructing an elaborate social insurance system covering many of the most dangerous industrial hazards. Thus commenced Phase II of American risk management policy. The goal now was to assure a secure environment for workers.

When All Else Fails book cover

Finally, beginning around 1960, we saw yet another shift—to Phase III. Increasingly, risk management policies were designed to protect the consumer and, even more broadly, the citizen at large. Product liability law, for example, was transformed into a powerful consumer protection device. At about the same time, the federal government became actively involved in protecting citizens against the ravages of natural disasters, such as earthquakes and hurricanes. In fact, lawmakers introduced a broad range of health, safety, and environmental policies under Phase III, all designed to make life less risky for the average citizen.

What explains these changes? My sense is that as Americans grew ever more affluent (particularly in the twentieth century), they became more and more interested in protecting what they had. And this meant that economic security gradually came to rival economic growth as a major social priority.

You asked about what a fourth phase might look like. Again, as a historian, I want to be careful about making open-ended predictions. Still, one might think about two possible trajectories. On the one hand, there is some evidence to suggest that Americans may be ready to scale back some of their security programs in pursuit of more growth. This would explain the widespread interest in product liability reform and Social Security privatization. On the other hand, in the aftermath of September 11 as well as the recent declines in stock values, we've clearly seen renewed interest in the idea of government as ultimate risk manager. And so, with respect to a potential Phase IV, I suppose we'll just have to wait and see how these (and other) competing pressures ultimately play out.

Q: What would you characterize as government's inherent weaknesses and strengths in risk management and how has this changed over time?

A: In terms of risk management, the main advantage that the government has is its power to compel, including its power to tax. This allows it to spread risks extremely broadly (even, in some cases, onto generations that have yet to be born) and to overcome a broad range of failures in the private marketplace. This is why, in my view, government truly is the ultimate risk manager.

Even with a new administration in place committed to downsizing government, there was virtually no debate whatsoever that the federal government should step into the breach.
— David A. Moss

At the same time, in designing risk management policies, lawmakers always have to be exceedingly careful about a phenomenon that economists call 'moral hazard'. The problem is that once people are covered by insurance, whether public or private, they tend to engage in riskier behavior, since they know that the insurer will cover any potential losses. In the public context, for example, the rise of federal disaster relief may well have accelerated building in areas that are unusually vulnerable to natural disasters, such as flood plains. This would represent a form of moral hazard. Some critics argue, moreover, that unemployment insurance has rendered workers less careful about keeping their jobs, that deposit insurance has made depositors less interested in monitoring the soundness of their banks, that product liability law has led consumers to be more careless in the way they use products, and so on.

While many of these criticisms are probably exaggerated, it is undoubtedly true that moral hazard is a major problem and that policymakers need to work hard to avoid it in constructing effective risk management policies.

In terms of change, which you asked about, I would point to three things. First, on the negative side, it seems clear that as public risk management has become more common, many more people have come to expect government bailouts in the wake of major losses, which only serves to exacerbate the moral hazard problem I just mentioned. Second, on the positive side, we've learned a lot over time about how to construct risk management policies—about what to do and, especially, about what not to do. So it may be that although the problem of moral hazard has increased, we are now in a better position to address it than we once were.

Finally, it seems almost certain that the information revolution we are now experiencing will influence the way that government manages risk in the future. With greater access to information, government officials may be able to overcome or at least diminish some of the government's traditional weaknesses as a risk manager. At the same time, however, the very same advances in information technology may allow private risk managers (such as insurance companies) to overcome some of their own traditional weaknesses, thus making certain types of public risk management less necessary. How this pans out is something that I plan to pay close attention to in the coming years.

Q: Your book seems particularly timely given all the recent debate as to the government's role in protecting the individual investor and in regulating the stock market. Do you see these recent events as an extension of what you characterize as Phase III with its concern for the individual homeowner and consumer or the beginning of a Phase IV?

A: In the wake of the recent stock declines and the various corporate scandals, lawmakers have certainly shown increasing interest in identifying ways to protect the small investor. In my view, this reflects an intriguing mix of Phase I and Phase III motivations—that is, an emphasis both on boosting investor confidence (Phase I) and on protecting the "little guy" (Phase III). These two motivations have come together, it seems to me, because stock ownership is now so much more widespread than it once was, as a result of 401(k)s and the like. We won't know for some time whether this marks a defining feature of an emerging Phase IV. But there can be no question, even now, that it represents a highly important development in the ongoing transformation of American risk management policy.

Q: How do the events of September 11th illustrate the role of government in risk management?

A: As I explain in the preface, I finished writing my manuscript nearly five months before the horrible events of September 11th. It seems clear, however, that in the wake of this monumental crisis, the federal government did indeed assume the role of "ultimate risk manager." Even with a new administration in Washington committed to downsizing government, there was virtually no debate whatsoever that the federal government should step into the breach, compensating losses and working to safeguard the public against a wide range of new risks. For example, Congress and the President immediately agreed on multi-billion dollar schemes to bail out ailing airlines and to compensate terror victims and their families.

Given the reputation of the United States as a bastion of laissez faire, many foreign observers were astounded at the nature and magnitude of the federal response to September 11th. One French economist complained that the Americans, who had long "been teaching the gospel of free markets," seemed suddenly "to forget the universal laws of the market." But the truth is that the federal response should not have come as a surprise, since American lawmakers had long demonstrated their willingness to act aggressively in managing major risks of all sorts. Even in the United States, therefore, government has always served as the ultimate risk manager.

About the Author

Laura Linard is the director of Historical Collections at Baker Library.