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Risk Doesn’t Stand Still

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe explores the movement and transformation of risks in adapting, self-referencing systems, of which financial systems are a notable example. In this provocative new book, the Wall Street Journal’s chief economics commentator Greg Ip contemplates how actions to reduce and control risk are often discovered to have increased it in some other way, and thus, “how safety can be dangerous.”

This is an eclectic exploration of the theme, ranging over financial markets, forest fires, airline and automobile safety, bacterial adaptation to antibiotics, flood control, monetary policy, and financial regulation. In every area, Ip shows the limits of human minds trying to anticipate the long-term consequences of decisions whose effects are entangled in complex systems.

In the early 2000s, the central bankers of the world congratulated themselves on their insight and talent for having achieved, as they thought, the Great Moderation. It turned out they didn’t know what they had really been doing, which was to preside over the Great Leveraging. Consequently, and much to their surprise, they found themselves in the Great Collapse of 2007 to 2009, and then, with no respite, in the European debt crisis of 2010 to 2012.

Ip begins his book two decades before that, in 1989, at a high-level conference on the topic of financial crises. (Personally I have been going to conferences on financial crises for 30 years.) He cites Hyman Minsky, who “for decades had flogged an iconoclastic theory of business cycles that fellow scholars had largely ignored.” Minsky’s theory is often summarized as “Stability creates instability”—that is, periods of safety induce the complacency and the mistakes that lead to the crisis. He was right, of course. Minsky (who was a good friend of mine) added something else essential: the rise of financial instability is endogenous, arising from within the financial system, not from some outside “shock.”

At the same conference, the famous former Federal Reserve Chairman Paul Volcker raised “the disturbing question” of whether governments and central banks “end up reinforcing the behavior patterns that aggravate the risk.” Foolproof shows that the answer is yes, they do.

Besides financial implosions, Ip reflects on a number of natural and engineering disasters, including flooding rivers, hurricane damage, nuclear reactor meltdowns, and forest fires, and concludes that in all of these situations, as well, measures were taken that made people feel safe, “and the feeling of safety allowed danger to re-emerge, often hidden from view.”

The natural and the man-made, the “forests, bacteria and economies” are all “irrepressibly adaptable,” he writes. “Every step we take to suppress the risks . . . will provoke some other, offsetting step.” So “neither the economy nor the natural world turned out to be as amenable to human management” as was believed.

As Velleius Paterculus observed in the history of Rome that he wrote circa 30 AD, “The most common beginning of disaster was a sense of security.”

Why are we like this? Ip demonstrates, for one thing, how quickly memories fade as new and unscarred generations arrive to create their own disasters. Nor is he himself immune to this trait, writing: “The years from 1982 to 2007 were uncommonly tranquil.”

Well, no.

In fact the years between 1982 and 1992 brought one financial disaster after another. In that time more than 2,800 U.S. financial institutions failed, or on average more than 250 a year. It was a decade that saw a sovereign debt crisis; an oil bubble implosion; a farm credit crisis; the collapse of the savings and loan industry; the insolvency of the government deposit insurer of the savings and loans; and, to top it off, a huge commercial real estate bust. Not exactly “tranquil.” (As I wrote last year, “Don’t Forget the 1980s.”)

“Make the most of memory,” Ip advises. After the Exxon Valdez oil spill disaster, he says, the oil company “used the disaster to institute a culture of safety . . . designed to maintain the culture of safety and risk management even as memories of Valdez fade.”

We often do try to ensure that “this can never happen again.” After the 1980s, many intelligent and well-intentioned government officials went to work to enact regulatory safeguards. They didn’t work. As Arnold Kling pointed out in an insightful paper, “Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008,” some of the biggest reforms from the earlier time became central causes of the next crisis—a notable example of Ip’s conclusions.

We are forced to realize that the U.S. housing finance sector collapsed twice in three decades. We may ask ourselves, are we that incompetent?

Consider a financial system. The “system” is not just all the private financial actors—bankers, brokers, investors, borrowers, savers, traders, speculators, hucksters, rating agencies, entrepreneurs, principals and agents—but equally all the government actors—multiple legislatures and central banks, the treasuries and finance ministries who must constantly borrow, politicians with competing ambitions, all varieties of regulatory agencies and bureaucrats, government credit and subsidy programs, multilateral bodies. All are intertwined and all interacting with each other, all forming expectations of the others’ likely actions, all strategizing.

No one is outside the system; all are inside the system. Its complexity leaves the many and varied participants inescapably uncertain of the outcomes of their interactions.

Within the interacting system, a fundamental strategy, as Ip says, is “to do something risky, then transfer some of the risk to someone else.” This seems perfectly sensible—say, getting subsidized flood insurance for your house built too near the river, or selling your risky loans to somebody else. But “the belief that they are now safer encourages them to take more risk, and so the aggregate level of risk in the system goes up.”

“Or,” he continues, “it might cause the risky activity to migrate elsewhere.” Where will the risk migrate to? According to Stanton’s Law, which seems right to me, “Risk migrates to the hands least competent to manage it.” Risk “finds the vulnerabilities we missed,” Ip writes. This means we are always confronted with uncertainty about what unforeseen vulnerabilities the risk will find.

Finally, the author puts all of this in a wider perspective. “My story, however, is not about human failure,” he writes, “it is about human success.” There can be no economic growth without risk and uncertainty. The cycles and crises will continue, so what we should look for is not utter stability but “the right trade-off between risk and stability.” The cycles and crises are “the price we pay for an economic system that encourages and rewards risk.” This seems to me profoundly correct.

Reader Discussion

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on May 03, 2016 at 09:23:34 am

[W]hat we should look for is not utter stability but “the right trade-off between risk and stability."

Great. Does the author offer some ideas about how to know when we've achieved such an optimal trade-off?

I don't know that I've ever encountered anyone who opposes the government intervention of guaranteeing deposits at certain financial institutions, at least up to specified sums. This practice might seem to not merely transfer the risk of a bank run to the feds, but pretty much eliminate the risk entirely. After all, why should depositors engage in bank runs at all if they know the feds have their back? But, of course, this is not entirely accurate: In some cataclysmic, Mad Max future, the feds may be unable or unwilling to fulfill on this promise. And then we'll read books (assuming people still write books) about how government interventions never work, blah, blah.

In short, people can always find cost to a policy, even a hidden cost, yet it does not necessarily follow that the policy's costs exceeds its benefits. But I have not generalized framework for anticipating when a risk-shifting policy is worth its cost.

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nobody.really
on May 03, 2016 at 11:20:54 am

" But I have not generalized framework for anticipating when a risk-shifting policy is worth its cost."

Yep!!! In the end, it is all guesswork, isn't it.

That being said, I think Mr. Ip is cognizant of that fact. after all, isn't his thesis that security = insecurity nothing more than a means of asserting that so much of what we do, what we strategize / conceive, etc. just a best guess estimate which attempts to measure costs and benefits.

It is probably more fun at the horse races but both the track and the market / financial systems leave large pungent deposits in their wake.

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gabe
on May 03, 2016 at 14:02:13 pm

The people seem bizarrely overlooked. It's as though the men and women of Gotham could care less about a civic people.

"The “system” is not just all the private financial actors—bankers, brokers, investors, borrowers, savers, traders, speculators, hucksters, rating agencies, entrepreneurs, principals and agents—but equally all the government actors—multiple legislatures and central banks, the treasuries and finance ministries who must constantly borrow, politicians with competing ambitions, all varieties of regulatory agencies and bureaucrats, government credit and subsidy programs, multilateral bodies. All are intertwined and all interacting with each other, all forming expectations of the others’ likely actions, all strategizing.

No one is outside the system; all are inside the system. Its complexity leaves the many and varied participants inescapably uncertain of the outcomes of their interactions." Where was the customer in that passage?

I think capitalism should be tweaked so as to coach each newborn so that that most girls and boys can achieve their Overstreet Transition (H. A. Overstreet, The Mature Mind, 1949) and embark on early adulthood (age 30) intending to live a full, rewarding life.

The first step in making that achievable goal happen is to imagine it. I think this forum is capable to propose the second step.

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Phil Beaver
on May 04, 2016 at 17:58:18 pm

I wonder whether risk, like energy, is indestructible. You can control it, you can harness it, you can shift it, but you cannot eliminate it.

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Wayne Abernathy
on May 04, 2016 at 19:23:21 pm

"You can control it, you can harness it, you can shift it, but you cannot eliminate it."

I don't agree with the quoted ideas. Physics, which is energy, mass and space-time, marches on regardless. It does not respond to humankind's controls, harnesses, shifts, or inaction. All humankind can do is try to understand and respond with due appreciation for discovered physics.

Most of humankind's woe comes from not understanding physics yet taking action without due respect.

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Phil Beaver
on May 05, 2016 at 09:41:26 am

[…] __ http://www.libertylawsite.org/2016/05/03/risk-doesnt-stand-still/ […]

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Image of The Beginning of Disaster is a Sense of Security | al fin next level
The Beginning of Disaster is a Sense of Security | al fin next level
on May 05, 2016 at 10:24:42 am

Humanity marches on, too, and so do human risks, i.e. economic and financial risks.

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Wayne Abernathy
on May 05, 2016 at 10:48:45 am

[…] J. Pollock reviews Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg […]

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Foolproof
on May 05, 2016 at 12:50:35 pm

Agreed.

Also, sometimes humankind or a particular society regresses.

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Phil Beaver
on May 05, 2016 at 13:14:37 pm

The problem here is the people have failed to notice the basic process that drives us forward in time. It is a feedback loop process that tends to follow a power law distribution. That means the future is heavily dependent on the past. Suppressing negative feedback (that's called stability) means that there will be a crash in the future.

Crash = Stability + Time

Problems grow during the stable times. Eventually, the problems spread far enough (if given enough time) so that there is a crash.

A System Collapse Framework for Societies | 1913 Intel - http://bit.ly/1PVKmkh

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Matt

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.