When safety gets dangerous. Book review of Foolproof, by Greg Ip.

December 10th, 2015 at 8:35 am

[What with the holiday season upon us, perhaps you’re looking for economic books for someone who likes that sort of thing, or, passively aggressively, for someone who doesn’t. Either way, I’ll try in the next few days to scratch out reviews of some of the econ-related books I enjoyed this year, starting with this great read from Greg Ip of the WSJ.]

Even seven years after the crash, you still can’t turn around without stumbling over another book on how the Great Recession came about. That’s not a bad thing, as this is an extremely important question, one posed by no less than Queen Elizabeth, who, on a visit to the London School of Economics in 2009, asked: “Why did no one see it coming?”

The economists’ answer to the Queen was that it was “a failure of collective imagination…to understand the risks to the system,” a standard and axiomatically true response. The implication is that we must figure out how we underestimated the risks and recalibrate our risk-mitigation infrastructure—our regulatory regime—to make sure we’re don’t repeat the same mistakes. That’s certainly the thinking behind the Dodd-Frank financial reform bill in the U.S. and the new and improved “macroprudential” initiatives (banking system oversight procedures) at central banks here and abroad.

But what if the problem is not that we’ve failed to make the banking system safe but that we’ve made it too safe such that reckless actions fail to trigger market discipline? What if, as the subtitle to economics journalist Greg Ip’s new book, Foolproof, puts it: safety can be dangerous and danger makes us safe?

Ip’s deep dive into these questions provides us with not just one of the more informative books on the financial crisis, but one of the more entertaining and readable ones. That’s in no small part because he goes well beyond the economic issues noted above into many other walks of life where risk is in play. There’s much here on the financial crisis and the troubles in the Eurozone, but there are also fascinating romps through football (where helmets can make heads less safe), seatbelts, air travel (don’t worry-it really is safe), forest fires, and insurance (somehow Ip makes insurance interesting: why do insurers keep underwriting disaster prone areas, and how did Warren Buffet figure out how to make a killing off of that?).

Ip’s insight is that these seemingly disparate areas are all related through the different ways we handle the risks they engender. Moreover, he believes that if we sufficiently analyze our history of trying to balance risk and safety, we can find the sweet spot wherein we neither allow excessive regulation and risk aversion to kill the golden goose of innovation, nor let the goose kill us by underpricing the threats we face.

Those with distant memories of micro-econ 101 will recall this as the “moral hazard” problem. As economists see it, many of our behaviors are driven by our desire to maximize benefits over costs. We want to do “cool stuff” but we don’t want to suffer for it. So we’d like to live right next to a river but don’t want to be flooded; we’d like to drive fast but don’t want to get hurt; we’d like to play football without a cumbersome helmet, but don’t want concussions; we’d like to buy a house with no downpayment but don’t want to face default and foreclosure. Moral hazard comes into play when we fail to take proper account of these tradeoffs. Insurance leads us to overly discount flood concerns; seatbelts convince us we can drive fast and not get hurt; “innovative” mortgage schemes give us a false sense of our ability to service our housing debt.

In simple economic terms, moral hazard occurs when we don’t face the true price of our actions.

If that all sounds pretty abstract, Ip provides many concrete examples of moral hazard at work and the pains of people and policy makers to engineer our ways out of it. I experienced the problem first hand as an economist in the Obama administration during the worst of the Great Recession.

It was clear at the time that thanks to the bursting of bubbly housing prices and the failure of the mortgage schemes alluded to above, many homeowners faced foreclosures. That’s obviously bad for them, but it’s also bad for the macroeconomy, as their indebtedness creates a lasting drag on growth. So an obvious solution is to write off a bunch of that debt, let them stay in their homes, and avoid the debt-deflation cycle we saw forming at the time.

While nobody loved the idea, a number of economists viewed it as necessary, the kind of break-the-glass emergency intervention you reserve for rare phenomena like the deepest recession since the Depression. But the political voices in the room overruled us on the basis of moral hazard. How are we going to explain to the Baxter’s, who’ve been working three jobs to stay current on their moderate mortgage, that we’re bailing out the Brown’s, who bought too much house in the first place and then partied when they should have been working?

And the politico’s had a point. Does anyone remember how the Tea Party got their name? I do because I recall trying to defend our weak-tea, moral-hazard-avoiding housing initiatives against Boston-tea-party-inspired rants that the administration was spending taxpayers’ money to bail out scofflaws.

But does that mean that debt forgiveness would have worked? In Ip’s framework, it might have worked once, but by staving off foreclosure, policy makers would have been setting the table for the next crisis, as excessive risk takers learned that they’ll be bailed out.

There’s something to Ip’s theory but I suspect our real problem here is less moral hazard and more the tendency of humans to neither sufficiently remember the past nor worry about the future: our discount rate for the future is far too high. Punishing people for the mistakes they made will only keep them from making them again if they remember. But we are wired to insufficiently connect what happened last time with what might happen next time. Balancing risks and safety is important, but even if policy makers calibrate that tradeoff perfectly, future behavior will not be adequately changed.

That’s one reason you can observe countries under every regulatory regime you can imagine going through booms and busts. It’s also why it has been so difficult to take actions against climate change, despite the existential threats it poses. Such risks are too far down the road for many of us to accept a tax on carbon today.

That doesn’t mean you ignore moral hazard. Ip tell us that to get the balance right, we need to listen to both “the engineers and the ecologists.” The engineers design risk reduction policies like safer financial practices (e.g., thicker capital buffers to absorb bank losses) or better levees against floods. The ecologists remind us that smaller fires need to burn to avoid larger ones, that antibiotics should be used sparingly, and that over-regulated economies may grow smoother but over the long run, they’ll grow too slowly.

Ip assures us that “the right tradeoff between risk and stability will maximize the units of innovation we get per unit of instability.”

That’s a fine aspiration but history suggests we’re incapable of finding that balance and thus need to broaden the model to include the high discount rate problem. That will lead to the imposition of policies that high discounters don’t want, like a tax on carbon and fiscal policies that better align—over the long term—tax revenues with spending plans. True political leadership in this sense means figuring out how to get enough people to care enough about the future to impose such burdens on themselves in the present.

There’s one final but essential piece of the model that also needs to be added on. Ip works and writes—far more engagingly than most—in the “neoclassical” economic model. Get the incentives right, balance risk and stability, and equilibrium conditions will prevail. But that ignores a huge force that economists often leave out: power.

Political power, economic power, racial, ethnic, and gender power are key determinants of economic outcomes in ways that we must understand and incorporate if we are to fully answer either Queen Elizabeth’s question or the questions Ip poses in Foolproof. The financial system didn’t just go off the rails—once again—because of regulatory mis-calibration or a failure of imagination by economists. It did so in part because concentrated wealth interacted with money in politics and policy to protect itself against market regulation.

Ask yourself why, as we speak, every Republican candidate for office wants to repeal Dodd-Frank and deregulate markets. It’s not because they’re engaging in Ip’s thoughtful balancing act. It’s because they’re doing their funders’ bidding. And we won’t balance safety and danger until we recognize that this too is part of the mix.

None of these shortcomings take away from the power and pleasure of Foolproof. To the contrary, Ip introduces a policy architecture upon which these additions neatly fit. In other words, the first step is to read this book. Then we’ll talk about building out the model.

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3 comments in reply to "When safety gets dangerous. Book review of Foolproof, by Greg Ip."


  1. Amateur says:

    Jared, I think the concept of moral hazard is taken out of context too easily. Moral hazard depends upon knowledge and mindset. This problem is often described in terms of people that deal in markets that are entirely about making money. Investing on mortgages, for instance. I don’t think moral hazard would have entered into the minds of those home owners who were potential recipients of a debt bailout. There were a small number of people gaming the system, flipping houses like crazy, and moral hazard does apply to them just as much as mortgage issuers. But the effect of how this was handled is that those most vulnerable to moral hazard (investors) were those that were bailed out, and those least susceptible to moral hazard were left in the lurch as the victims of investors.

    I don’t know why this narrative hasn’t caught on because it is correct. I suspect that rich people are so dominant that even those who mean well have trouble separating the truth from the lies (marketing ploys by another name).

    P.S.

    I eluded to releasing a product a while back. Well, it is finally ready from the perspective of my my previous mindset. But some testing and marketing input has convinced me I need about 6 more weeks to make it an EXTREMELY compelling product upon release. I’ll let you know soon after first release. The TOP silicon valley capitalists are already trying to copy me and chase me down, it is obvious. I’m not mentioning names (top of the top).


  2. Amateur says:

    I should add a caveat. I don’t expect economists to engage in what I’ve created. Just the opposite, I think. I think they’ll be repelled by it, because it doesn’t give them the coveted chair of the wise one.

    Everyone has a chance here, just like we believe in our dreams. Everyone can speak. Everyone should speak.


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