Translation: Shifting the risk to the taxpayer

I’m seeing a lot of this recently (via Twitter)

The Israeli model is successful because the Israeli government, rather than funding incubator managers, invest in start-up companies to the tune of $500k to $750k. The model integrates 85% government and 15% private first stage investment, with the government input reducing risk at the early stages of a company. The government is repaid through royalties.

Lets think about this model a bit.  This isn’t the risk “disappearing” – this is the government (read taxpayer) taking on the risk.

Furthermore, risk is not independent of the choice of the private individuals running the firm – depending on the way these contracts are structured the firm may take on more or less risk then they would have otherwise.  So not only does this involve putting risk on taxpayers, it also involves distorting the incentives for the firm itself … nice

More broadly this raises an interesting point for me – it is almost as if we do not believe firms should make any “rents” from innovation … unless the government explicitly decides to give them rents to innovate.  Isn’t this strangely perverse?  What sort of implied model of society does this make sense in?

Sure we can try building up some type of externality, but let us be a bit careful we are looking at the issue in an objective way rather than just trying to build up a ex-post justification for doing what we wanted to do in the first place 😉

From what I can tell, the problem is that we all tend to look at issues too much in isolation when we look at them quickly – there is too much static partial equilibrium (at best) logic used without thinking of the broader dynamic and general equilibrium effects … the ones economists are obsessed with.  I love comparmentalising problems to help understand them, but when it comes to policy we have to fit it all together!

And this is what CGE (Computable General Equilibrium) and other similar types of models are trying to do – and why they often surprise us relative to our raw intuition.

Note:  You may say that society should take on some risk as the firm is the one “making things”.  I would note that the firm, and their interactions with others, get the benefit from “things” – trying to get the rest of us to take on risk for firms their own private benefit is and then pretending “jobs” and “output” are somehow benefits to people uninvolved with the transaction is not a justifiable argument.

  • john small

    Good question, but do we know enough about these contracts to make a call? If the private party remains on the hook for the government investment, then the risk hasn’t been shifted, at least not permanently. In that case this scheme could just be a way of addressing an “access to capital” constraint on start-ups.

    • So if we have a situation where the firm owners have unlimited liability and sufficient equity this isn’t a worry. Indeed, but this isn’t the situation – and in fact, if this was the situation why are banks not willing to lend?

      Is our premise then that financial institutions are too conservative? If so, if that consistent with our view of financial institutions lending behaviour due to the existence of an implicit government guarantee?

      • john small

        Yes, to justify this policy it would need to be the case that financial institutions are “too conservative” in some sense. That certainly has happened before in the history of the world – as the successful rise of microfinance shows. Mind you, that also shows that markets can fix some of these problems.

        Not sure what the story is in Israel regarding implicit government guarantees, but its a patchy landscape in NZ isn’t it? Plenty of finance companies have gone to the wall, though SCF got a bail-out.

        • My key thought with this is that we need to make sure our views and policies are consistent – simultaneously saying that credit is too tight and financial institutions are too conservative, then saying that credit is too loose and financial institutions too risk (ergo macro prudential regulation) is inconsistent.

          People will say, but its too tight for small firms and too loose for households – banks are pricing risk in the wrong way. This is an argument I’ve heard and something I do not find self-evident, I have to be honest!

          • john small

            fully agree re consistency. also agree that its not obvious that banks are not pricing risk in a socially optimal way. but that is entirely possible.

            • Market failures are definitely possible – like to see the argument made directly rather than what we often see 😉

              • john small

                me too. i wonder how influential the RBNZ’s prudential rules are here. they affect the cost of funds for a bank and they differ by risk class. that structure could easily mis-direct loan finance.

                • Indeed, this is a very very important issue. I used to be more concerned about it than I am now, but it is something that really needs to be discussed by economists. I’ve also seen Gareth Morgan and his team discussing it more recently.

                  I discussed briefly here:


                  One of the key things is that the most “binding” rules are quite recent, and are less binding than they have been overseas. As a result, this is more an issue for thinking about a future – than necessarily an explanation of misinvestment in the past (which some have tried to make it about).

                  It is an issue I am under the impression the RBNZ is thinking about – and one that makes me nervous about to much central bank micromanaging through setting relative risk too directly. One of the reasons I have a preference for straight equity based regulation, or clear rule based policy: