The big blow ups?

Margaret Wente, in the Globe and Mail this week, writes that we live in an era of big “blow ups” that cannot be stopped.

The problem, as I see it, is not that Wente’s smartest people in the world have no idea how to stop it.  It is a combination of:

• People who think they are the smartest, but are not, trying to control things they don’t understand or refuse to understand the law of unintended consequences…
• The smartest people being sidelined because they make the “not smartest people” fearful
• The smartest people being prevented from do what would solve the problems because of bureaucratic restrictions, fear of retribution, or fear of being second-guessed.

On the subject of economics, the problems of the last few years are not failures of free market capitalism.  They are failures of government regulation to foresee how the free market would react to such regulation.   Reducing interest rates to sub 5% levels for nearly 10 years, coupled with government policies to restrict housing development in many areas, coupled with government policies created to increase home ownership did two things – it drove up demand and reduced supply.  Prices rose – as should be expected under a free market.  The problem became that people, and businesses, believed that prices would continue to rise, and therefore boring at very low interest rates against such assets was a good idea.  And for those individuals, this was a perfectly rational decision – except that the party couldn’t continue, because there was too much debt piling up and interest rates can’t stay at zero forever.

If interest rates were set in the free market (solely), they would have risen significantly as the level of debt in society increased – because lenders would fear defaults and want a larger return for the larger risks they were taking.  But with the government setting interest rates and backstopping banks lending into the market, the free market was solely distorted.

On the subject of oil drilling and the safety and environmental issues, it is only in times like this that the engineers are tasked with the exciting job of “fix it now and cost is no object”.  The problem is that it should have been avoided.  But how many businesses will keep working with a piece of machinery that is dangerous because stopping to wait to replace it will have significant negative financial impacts.  And what if the person who should make that decision, to shut down the plant to replace the equipment, has their job on the line based on the financials?  In some cases, those individuals will take the risk on the unsafe equipment because the risk to themselves (their livelihood) is greater than the potential consequences of the failing equipment.   As many incidents have shown, both in industry safety and the financial markets, the human ability to quantify risks is skewed.  Very unlikely events with very bad consequences are often underestimated because of their low probabilities – if you ever hear someone say “but that will never happen”, they have done exactly that.  The history of industrial accidents is filled with such events.  The financial crisis and the Deepwater Horizon incident follow this pattern.

Sometimes, mathematically modeling can help – as it does in the case of real insurance in large markets.  It makes senses to buy insurance for some events because it is cheaper for all of us to pool the risk.  This is even the logic of the hedge funds that try to “hedge” out risk.  But if the risks are underestimated (or misunderstood), when they happen all hell can break loose.

But sometimes, you just need to rely on the smart people, be it the engineers, financial wizards, scientists – to be allowed to make a call and the rest of us have to accept they won’t always be right – but we might be better of than demanding they always be right and therefore are too frightened to speak out or act.