Citizen Economists » risk management

How Should We Respond to a Small Risk of Catastrophe?

Winton Bates — Mon, 01 Nov 2010 15:44:27 +0000

I try to remember to pay house insurance premiums. Otherwise, I tend to avoid thinking about small risks of catastrophe. There are plenty of other things to worry about.

This avoidance strategy usually helps me to maintain a positive state of mind until someone manages to ambush me with the thought of how dreadful it would be if one of those catastrophes actually occurred.

The last time such an ambush had a lasting impact on me was in March this year when I was reading ‘The Science of Liberty’ by Timothy Ferris. This book contains an excellent discussion of the historical links between liberty and the advance of knowledge. I tend to trust Tim Ferris’ judgement on scientific matters. (I have previously written about his book here.)

Tim Ferris’ discussion of the science of climate change begins in a fairly low key fashion until he reaches the point where he suggests that greenhouse gases generated by human activity constitute the most plausible explanation for the gradual increase in the earth’s average temperature since the beginning of the 20th Century. Then, in the following paragraph, he proceeds to suggest progressively less benign consequences of further global warming until, at the end of the paragraph, he mentions the possibility of runaway warming. The next paragraph reads:

‘On which point it may be useful to contemplate Venus, the brightest planet in the sky. Venus is virtually Earth’s twin – the two planets have the same diameter and the same mass – but while much of the earth’s carbon is bound up in its oceans and plants and in fossil fuels like coal, oil and natural gas, the carbon on Venus resides in its atmosphere. The surface temperature on Venus is 457 degrees Celsius, hot enough to melt lead. Should the earth be pushed into runaway greenhouse warming, it might wind up resembling the Venus of today’ (p. 282).

This wasn’t the first time I had heard about the possibility that Earth’s future could be like Venus. On previous occasions, however, it was obvious that scare tactics were being employed and my defences were activated well before the Venus card was played.

Cartoon by Nicholson from “The Australian” newspaper: www.nicholsoncartoons.com.au

I was reminded of Tim Ferris’ invitation to contemplate Venus while reading ‘The Rational Optimist’. Matt Ridley, the author of this book, adopts a very different position. He begins the discussion by mentioning Martin Weitzman’s argument that if there is some possibility of a huge disaster resulting from global warming, the world should take steps to avoid it. He then suggests that the problem with this reasoning is that it applies to all risks, including the remote possibility of collision with a large asteroid.

I agree with Robin Hanson’s view, in his review of Ridley’s book, that some action may be warranted to reduce the potential impact on human well-being of any potential catastrophe. How we should respond should depend on the nature of the potential catastrophe, the probability that it will occur and what can be done to avoid it.

How should we respond to the small risk of runaway global warming? A fairly obvious answer is to put a tax on carbon emissions in order to provide incentives for development of technologies that generate less CO2, accompanied by an appropriate subsidy for activities that remove CO2 from the atmosphere. In many countries it would be possible to do this at little or no economic cost by substituting a carbon tax for other taxes that impose greater economic distortions. It is important to emphasize, however, that the main aim of the exercise should be to put in place incentives for development of better technologies.

Matt Ridley makes a strong case that climate mitigation is currently being mismanaged and that this mismanagement could be more damaging to human well-being than climate change itself. By encouraging a return to the medieval practice of using biofuels as an energy source, governments have added to misery in poor countries by raising the price of grains and have provided incentives for the further destruction of rainforests. In addition, incentives for greater use of costly wind and solar technologies are raising the cost of electricity substantially for little benefit in terms of reduction in CO2 concentrations in the atmosphere.

It is possible that solar technology will become competitive at some time in the future, but subsidizing use of current solar panel technology will not make that happen. If solar panel technology ever becomes competitive it will not need to be subsidized to enable scale economies to be achieved.

I think the current mismanagement of climate mitigation is attributable to scare tactics and panic. Some of us have grown so accustomed to environmental scare tactics that we find it difficult to take seriously the idea that a small risk of catastrophe is worth considering. Others have been too easily panicked into supporting costly policy responses that seem to be directed toward reducing CO2 as rapidly as possible irrespective of cost. The outcome of these conflicting forces in Australia has been a policy to encourage increased use of existing renewable energy technologies that are still highly inefficient. This policy achieves only a small reduction in CO2 emissions per additional dollar spent. (My test of how genuinely concerned a person is about reducing CO2 emissions in the short term is whether they are in favour of the nuclear power option, which seems to be the best alternative to use of fossil fuels that is presently available. )

There are signs now emerging that people in Australia are becoming concerned about the cost of rising energy prices attributable to the silly policy of encouraging greater use of high cost renewable energy. Hopefully similar concerns in other countries will result in adoption of sensible strategies to encourage development of less costly technologies over the next few decades.

Market as Regulator

Thersites — Thu, 09 Apr 2009 13:20:42 +0000

Regulators
We regulate any stealing of his property
And we damn good too
But you cant be any geek off the street,
Gotta be handy with the steel if you know what I mean, earn your keep!
Regulators!!! mount up!

The epic words of Warren G in many respects seem to sum up our government’s regulatory regime. Guys like Barney and Timmy clearly are “handy with the steel,” in their ability to influence businesses. They also in many respects do regulate stealing, ultimately robbing investors and businessmen in creating moral hazard for the bond and shareholders and all sorts of barriers to entry for the firms.

Yet recently amidst the market fallout there have been calls left and right for some sort of even more powerful “super-regulator.” After all, given that our regulatory architecture seems to have failed us this time, why not create an even bigger and stronger one to prevent the crisis next time?

Just like all government attempts to stop future crises, be it in healthcare or food and drugs, regulation always perpetuates the problems, creating greater ones down the road. In the financial system, we see perhaps the greatest case AGAINST regulation. Let us examine my seemingly counterintuitive claim.

The first and most obvious reason against regulation is that it creates a significant amount of moral hazard. If one has the SEC there to ensure that financial institutions are seemingly playing by the rules, or the FDIC there to ensure that even if a bank is insolvent, one will be able to receive his deposits (up to a point), then this encourages one to take far greater incremental risks than they otherwise would. After all, with the seal of approval of a government institution, why would you ever get your hands dirty in analyzing the institutions in which you entrust your money?

This problem is especially pervasive when it comes to the credit ratings agencies, namely Moody’s, S&P and Fitch, who are designated “Nationally Recognized Statistical Rating Organizations” by the SEC. Individual investors and institutional investors alike had become reliant on these agencies to gauge the risk of default of individual companies and securities, only for many of these companies and securities to blow up in their faces during this crisis. Had people actually gone in and done the risk analysis themselves, as opposed to relying on ratings assigned to companies largely by government decree, I would argue that people would have taken far more prudent positions with their capital.

Further, without this pseudo-cartel of agencies, I would imagine there would grow hundreds if not thousands of competing private firms to do independent analysis, greatly benefitting the investor without the time or knowledge to do financial analysis. Sure some of these companies might partake in fraudulent activities themselves, but they would either lose credibility and have to fix up their act to compete, or be prosecuted for the fraud they perpetrated. I admit that in this case, you do need a police force to enforce the law when it comes to fraud, but it is far more likely (given all of the times that private companies for example had uncovered the Madoff scheme before the regulators ever did anything) that the authorities would be able to react were market participants able to signal fraud to them. Still, at the very least the consumer would have far more choice in determining which analysis was best.

This brings us to another problem with government regulation – the fact that it is done by government monopoly. Government officials just like businessmen are prone to error. Unlike businessmen however, they lack a profit motive to work efficiently and prudently. To this end, if we see how ineffectual the DMV is, why should the SEC or FDIC or SIPC or any of these other alphabet-soup agencies be any more trusted? Sure, many of the people that work for these agencies previously worked in private industry, but remember that this in itself creates many a conflict of interest. Madoff himself had ties to the SEC, which may have helped him keep his Ponzi scheme alive for so many years.

Government regulators also create problems in that they make costly work for businesses and investors. SARBOX and other forms of compliance cost businesses small and large millions each year, while the regulators’ decisions to allow off-balance-sheet financing in many ways incentivized companies to hide the risks that should have been plain as day to investors. All of this is bad for transparency and efficiency, two things regulators are supposed to encourage.

On the other hand, there is the crazy idea of letting the market serve as the regulator. I would argue that discerning, self-interested investors have the best judgment when it comes to the valuation because they are responsible for their money. For it is the market that assigns a price to securities – riskier ones command a higher risk premium. Companies that make mistakes, be it through poor compensation standards that reward incompetence, poor investment projects, etc will face prohibitive borrowing costs and lower stock prices, and ultimately if the market so chooses be taken under. It is this playing field that ensures regulation. The mercy of the market will hold people accountable. Government regulators, government-empowered ratings agencies and others merely create the moral hazard that stop this system from functioning properly.

When government regulators set a precedent of bailing people out for bad behavior under the guise that a company is “too big to fail,” you further destroy the regulation of the market. You encourage excessive risk-taking; you encourage striving for short-term gains at the cost of long-term sustained profitability. You hurt the investors who are trying to signal through bond and share prices that a firm is in bad shape, and ultimately hurt taxpayers if you make the private problems of some investors into the public problems of all Americans. To let bureuacrats go in and say that a company is stable, often disingenously, as opposed to letting investors speak with their money is as arbitrary as it is abominable.

The fact of the matter is that government doesn’t want to let the market work as it did in blowing up companies with worthless assets (even if it was the moral hazard built into system and intervention that caused creation and investment in these assets), because it will destroy the interests that prop the elected officials up, destroy their own wealth, undermine their power (wouldn’t want to waste a crisis) and further cause unrest amongst the populace.

But the short-term dislocation versus the long-run fiscal and moral decay of the country is incomparable. The former will lead to an economy and a nation made stronger; the ladder to tyranny. The problem in our system is that if you are a politician and trying to get reelected, you make this calculation and hope that things don’t collapse at the wrong time, namely under your watch. Interestingly, this sacrifice of long-term sustainability for short-term gain is just the calculation made by many at the banks who played with essentially free house money (courtesy of the Fed), leading us to the crisis today. But let these same government officials who in large part mucked things up the first time around gain even greater control over the economy. I dare you.