Stuff happens

groupthink (1) In this NY Times op-ed, Richard Thaler picks up on a theme that Ken Rogoff and James Hamilton raised last week ñ the similarity between the miscalculation of risks relating to the Gulf of Mexico oil spill and the Wall Street financial crisis:

AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isnít fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.

For the financial crisis, it has become clear that many chief executives and corporate directors were not aware of the risks taken by their trading desks and partners. Recent accusations against Goldman Sachs suggest the potential for conflicts of interest among banks, investors, hedge funds and rating agencies. And it is clear that regulators like the Securities and Exchange Commission, an agency staffed primarily with lawyers, are not well positioned to monitor the arcane trading strategies that helped produce the crisis.

The story of the oil crisis is still being written, but it seems clear that BP underestimated the risk of an accident. Tony Hayward, its C.E.O., called this kind of event a ìone-in-a-million chance.î And while there is no way to know for sure, of course, whether BP was just extraordinarily unlucky, there is much evidence that people in general are not good at estimating the true chances of rare events, especially when human error may be involved. [.  .  .]

How can government reduce the frequency and the severity of future catastrophes? Companies that have the potential to create significant harm must be required to pay for the costs they inflict, either before or after the fact. Economists agree on this general approach. The problem is in putting such a policy into effect.

Suppose we try to tax companies in advance for activities that have the potential to harm society. First, we have to have some basis for estimating the costs they may inflict. But before the recent disasters, companies in both the financial and oil drilling sectors would have claimed that the events we are now trying to clean up were, well, one-in-a-million risks, suggesting a very low tax.

Alternatively, an offending party could be made to pay after the fact, by holding it responsible for the costs it imposes. BP has volunteered that it will pay for all damages it considers ìlegitimate,î but we can expect a fight over how to define that word.

.   .    .  Suppose a company worth only $1 billion was responsible for this accident. It would go bankrupt and we would be unable to collect. And if we arenít careful, we will encourage companies that have enough money for collection to leave the drilling to those that donít. [.  .  .]

We are left in a difficult place. Neither the private nor the public sector seems up to handling these kinds of problems. And we canít simply wait for the next disaster, because, as people might say if they had to use G-rated language, stuff happens.

Professor Hamilton zeros in on the group dynamic that leads to the underestimation of risk:

I think part of the answer, for both toxic assets and toxic oil, has to do with a kind of groupthink that can take over among the smart folks who are supposed to be evaluating these risks.

It’s so hard to be the one raising the possibility that real estate prices could decline nationally by 25% when it’s never happened before and all the guys who say it won’t are making money hand over fist.

And this interacts with the forces mentioned above. When the probability of spectacular failure appears remote, and moreover it hasn’t happened yet, it’s hard to set up incentives, whether you’re talking about a corporation or a regulatory body, in which the person who makes sure that the risks stay contained is the person who gets rewarded. When everyone around you starts thinking that nothing can go wrong, it’s hard for you not to do the same. It can become awfully lonely in those environments to try to be the voice of prudence.

Finally, Cato’s Gerald O’Driscoll, Jr. notes the futility of reacting to the oil spill by implementing even more regulation:

What is the missed lesson from all this? When President George W. Bush had his Katrina moment, the federal government’s bumbling response was blamed on him, on the Republicans, and on conservatives. Now it is President Obama’s turn. His administration’s faltering response to the disaster in the Gulf is attributed to his personal failings, staff ineptitude, communication failures, etc. And, of course, the two administrations have shared responsibility for the poor handling of the financial crisis.

A big-government conservative administration failed in crisis, as has a big-government liberal administration. The regulatory state did not prevent excessive risk taking whether in financial services, nor perhaps in offshore oil drilling. Government response to crises once they occur is slow and inept. All this is not because either Republicans or Democrats are in power, but because big government doesn’t work. It can’t deliver on its promises. Big government overpromises and underdelivers. In reaching to do more, big government accomplishes less. That is not an ideological statement, but an empirical observation.

In the case of financial services, virtually all the proposed regulatory reform offers more of the same. Additional regulations will be added to existing ones without addressing why existing ones failed to prevent the crisis. The same process will likely happen with respect to offshore drilling.

The oil spill has triggered an important debate about the value of off-shore drilling, and that debate might conclude that off-shore drilling generates more harm than benefit.

But despite the nightly photos and videos of the oil spill on television, itís important to remember that drilling produces benefits in addition to its costs. Deep-sea drilling has been ongoing for decades with relatively few incidents that even come close to the current spill.

So, while this spill may reveal that deep-sea drilling is too risky, itís also quite possible that this incident was simply the result of poor decision-making combined with bad luck, and that there is a nominal chance that it will reoccur.

And it is very difficult to regulate bad decision-making and bad luck.

ff happens, indeed.

3 thoughts on “Stuff happens

  1. “Deep-sea drilling has been ongoing for decades with relatively few incidents that even come close to the current spill.”
    I’d much rather have our situation than Nigeria’s. We might not be able to avoid our current catastrophe through private or public mechanisms. But whatever we’re doing, we’ve done a damn fine job avoiding their hellish issues. I’m assuming the same companies who are scrambling to assure our regulators are over there thankful to be without such worries.

  2. “But before the recent disasters, companies in both the financial and oil drilling sectors would have claimed that the events we are now trying to clean up were, well, one-in-a-million risks, suggesting a very low tax.”
    You would think a supposedly educated journalist would see the obvious error in this logic.

  3. Part of the unspoken rationale for importing vast quantities of oil was that we were exporting the environmental risks and degradation associated with domestic on shore and off shore production. Further, oil was easier to extract in other places and therefore less overall environmental risk was run and it was cheaper. Nevertheless, importing had its own risks. From the Exxon Valdez to the creation and empowerment of petty despots who could project power and propoganda to our great disadvantage. These risks were also difficult to predict and quantify but nonetheless were clearly real.
    Salting risks throughout the financial system and exacerbating those risks by mandating bad incentive structures in the financial industry was not even based upon as rational a thought process as the one which resulted in importing vast oceans of oil. In fact, it appears to me that unwise governmental tinkering in financial incentives and products may have been central to precipitating the financial crisis in the first place.
    What the regulatory state is intended to achieve is a world without risks. That has never been and never will be. Men (and women) are fallible and are not great at predicting the future. Stuff happens indeed.

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