Why catastrophic events like the sub-prime mortgage crisis and climate change are inevitable
Can our society take pre-emptive action to forestall devastating climate change? Can it act now to avoid wars over oil and natural gas? Can it take steps today to avoid economic crises stemming from spiking oil prices? The answer, unfortunately, is no, no, and no. Our institutions, public and private, are not designed for prudent action. They are designed to facilitate risk taking and to address negative consequences, if they arise, later on. Only in the face of disaster, when there is a clear and present danger, are we capable of mobilizing an appropriate response.
The problem is not ignorance; it is not that we are unaware of the risks we take. Nor do we lack the instruments to deal with them. The problem, deeply embedded in the architecture of our decision making, is that in the pursuit of economic growth we privatize reward and socialize downside risk. To describe this tendency, economists borrow a term, “moral hazard,” from the insurance industry. A moral hazard exists whenever decision makers in risky situations reap the rewards from their decisions without bearing all of the costs. The ability to pass downside costs on to others encourages imprudent decision making.
Our society is ridden with moral hazard. Limited liability is built in to our most important programs and institutions, and it has clear advantages. It makes our society dynamic; we dare the future, and that dare has paid handsome dividends. In a mere 200 to 250 years, it has made us wildly rich. Modern market capitalism is how we engineered our escape from the Malthusian trap, the subsistence living that has characterized human history, enforced by periodic outbreaks of war, famine, and disease.
But modern market capitalism has also exposed us to new orders of potentially catastrophic failure. Catastrophic, because by the time a potential problem becomes recognized as a clear and present danger, no action may be sufficient to prevent social and economic breakdown or, worse, war. In complex systems, tipping points may produce viral effects. Consider the violence in countries caught up in the Arab Spring. Think about the riots in southern Europe after the global economic crisis. Once set in motion, such events often acquire a momentum of their own and can lead anywhere.
The financial crisis in the United States illustrates how both private and public institutions can proceed into an icefield, full steam ahead, with full knowledge of the risk. Here is what Alan Greenspan, former chair of the Federal Reserve Board, wrote about sub-prime mortgages in his memoir, The Age of Turbulence : “A difficult problem is that much of the dubious financial-market behavior that emerges during the expansion phase is the result not of ignorance that risk is badly underpriced, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.”
Of course, private companies, and banks in particular, are not supposed to make reckless bets just because their competitors do, which is why Greenspan resisted further regulation. But they did, and later it became obvious why: moral hazard. When the masters of the universe who control decision making on Wall Street are confronted with enormous short-term personal rewards and minimal long-term downside risk, then disaster awaits.
But if you think imprudent decision making is a private sector phenomenon, think again. Here is Alan Greenspan on the public sector response before the sub-prime mortgage crisis: “I am also increasingly persuaded that governments and central banks could not have importantly altered the course of the boom either. To do so, they would have had to induce a degree of economic contraction sufficient to nip the budding euphoria. I have seen no evidence, however, that electorates in modern democratic societies would tolerate such severity in macroeconomic policy to combat a prospective problem that might not even materialize.”
As the ultimate Washington insider, he knew how governments actually function, as distinct from how we think they do. Americans at all income levels were benefiting from the housing boom—although some more than others, to be sure. The very rich were getting richer, but unemployment was low, inflation was down, and homeowners everywhere were enjoying increases in their personal net worth, or spending sprees bankrolled by mortgage refinancing. Woe to any government that proposed to take away that punch bowl, especially on the strength of forecasts by the few observers who warned that something might go wrong.
When it did, governments stepped in to rescue the banks, because, according to conventional wisdom, they were “too big to fail.” The collateral social and economic costs were considered too massive to contemplate. Then, realizing that they were creating a further moral hazard, proponents of the bailouts felt compelled to increase regulation. But rules do not facilitate innovation. Nor do they necessarily make society safer. Aggressive innovators are always ahead of their regulators, who often succumb to groupthink, coming to share the perspectives of those they govern. And sometimes the authorities are suborned, turning a blind eye to malfeasance. Indeed, one could argue that more regulation is a bad idea, because it encourages the belief that the powers that be are standing guard when in truth they may not be.
The sub-prime mortgage crisis exposed a deep ideological fault line in society. On one side are people who quite logically oppose regulation as both counterproductive to the economy and a violation of individual rights. On the other side, an almost equal number who, again quite logically, believe bailouts and other forms of social insurance are necessary, both to contain collateral damage and to show compassion. What to do? The answer is obvious: split the difference. Forgo regulation to get the party going; and then, when it comes crashing down, bail out and otherwise pump up the most important partygoers. In such a society, however, there is only one gear: fast forward.
One can make the case that finance is an exception. It is, in the sense that it can rip apart the socio-economic and political order of things—witness southern Europe. While debt serves as the lubricant of market capitalism, using other people’s money to pursue one’s own purposes carries an implicit moral hazard. The buildup of debt relative to income in society is like the buildup of methane in a mine: all it needs is a spark to set it off. Alas, higher debt levels are an almost inevitable outcome of greater income inequality. The very rich, who cannot possibly consume all of their wealth, must lend an ever-increasing share of it to finance not only capital investment but also consumption. Without mass consumption, the awesome productive capacity of capitalism falters, leading to economic recession, even depression. That was the enduring lesson of the Depression of the 1930s.
Spiking energy prices, which provided the spark that touched off the global financial market meltdown, are highly destructive. As we have seen so often in the past forty years, rising energy prices depress consumption among low- and moderate-income households. The result, exacerbated by high personal debt levels, is a severe negative impact on national income and employment. Technological innovation gets more attention, but growth in per capita income also depends on access to energy. Without it, tools are useless. Imagine yourself in the world’s most sophisticated city with no electricity. Nothing works. GDP measures our ability to use tools to alter our environment to suit our tastes. An individual’s income is simply a reflection of his or her control over energy (including food, which is just energy fit for human consumption), meaning the poor are virtually powerless.
More than 80 percent of the world’s primary energy comes from fossil fuels, which are already priced in global markets, in the case of oil, or soon will be in the case of natural gas and coal. So fossil fuels bring with them the potential for repeated and dramatic price spikes related to resource depletion and war on the one hand, and on the other the issue of climate change, with its promise of increasingly intense natural disasters. No one thinks consumers or private corporations will deal with these issues. They will continue to do what consumers and corporations do, which is to take whatever actions are necessary to ensure their own short-term benefit or survival. Most of us will proceed on the assumption that if a problem arises in the future, our governments will deal with it.
And we will be wrong, because political decision making processes are also fundamentally flawed. The political marketplace is a study in dysfunction, starting with the incentive structure confronting electorates. Voters are for the most part ignorant about the complex details of public policy; in a representative democracy, it is the leaders they elect who make the important choices about competing public policies. So instead of focusing on policy, the public focuses on character. A politician’s character is thought to be important in decision making, and character, in this case, goes not just to what is known of a politician’s personal behaviour, but to his or her avowed political beliefs, or ideology.
It is no surprise, then, that competition in the political marketplace emphasizes character assassination and branding. Character assassination discredits everyone in the process, and branding requires huge expenditures on advertising, which is increasingly paid for by private interests with political and economic agendas. This undermines the public trust. In the US, which has a rigid system of checks and balances, it also produces political paralysis—except in times of crisis. These negative outcomes are only exacerbated by the fact that political rhetoric today is designed to appeal to voters’ emotions rather than their intellects. Modern psychology and neuroscience may be even more influential in political versus consumer marketing, because the purpose of political speech is simply to persuade the voter to take a small personal risk—not, as in the consumer marketplace, to override his or her vested interest in getting a product that actually works as advertised.
All of this emboldens candidates to act opportunistically in the pursuit of what matters most to them: winning the next election, which tends to loom in the immediate future. The greatest risk in this dysfunctional process is to policies that impose an immediate cost in return for a long-term benefit. Case in point: the run-up to the global financial crisis, in which electorates were disinclined to support restraint as a means of avoiding something that might or might not go wrong at some unknowable time in the future. There are always politicians willing to offer the policy option with the least short-term cost or the greatest short-term benefit, because once they leave office they are no longer accountable. In this context, all political competitors have a powerful incentive to punt tough choices into the future. And they are often abetted by public accounting processes that would make Enron look virtuous. The net result of these factors is to make governments incapable of taking action unless and until they face a widely recognized, clear and present danger—although by then there is always a chance that it may be too late.
Our inability to consider the long-term consequences of our public policy decisions is compounded by the growth in income and wealth inequality. Economists debate the appropriate social discount to be applied for damages done to future societies by climate change thirty, fifty, and 100 years from now. But for the growing numbers of poor and near-poor who live paycheque to paycheque in today’s societies, thinking about the future is a luxury. Burdened with debt and highly vulnerable to such adverse contingencies as job loss, illness, divorce, and unplanned pregnancies, they cannot afford to contemplate the idea of deliberately raising the price of carbon energy now to avoid some future cost or problem. Energy, including food, already takes up far too large a portion of their household budgets, which is what makes the economy so vulnerable to rising energy prices.
Every politician knows this: that when it comes to energy, we are all trapped, because the poor and near-poor are trapped. Some will argue that revenue raised from a carbon tax could be used to reduce income inequality and thus mitigate the net negative impact on employment and economic growth. However, this ignores the fact that, while North America is second only to China in fossil energy output, its production is concentrated in just a few provinces and states—and the voters in those provinces and states are unlikely to stand by as central governments redistribute their income and wealth, no matter the merits. In Canada, regional differences have made a national energy policy based on carbon pricing a political non-starter; the federal government does what it has to do anyway, which is follow the US.
If America were to adopt an aggressive policy on climate change, Canada would have to follow. But that is not going to happen. The power of regional interests in the US is nowhere more apparent than in the Senate, in which two seats are allotted to each state, regardless of population. To prevent minority interests from delaying or even killing legislation by prolonging debate, three-fifths of the sitting senators (usually sixty out of 100) can force closure. Even more problematic is the rule that requires two-thirds of senators to allow ratification of an international treaty; in the absence of such an agreement, no real progress will be made in addressing global warming. In the recent US elections, climate change was seldom mentioned, even though the man who was re-elected president is on record as saying he believes it is an issue.
Sadly, we have no capacity to change our institutions from within, because our willingness to privatize reward and socialize downside risk is protected by powerful constituencies on both sides of the political spectrum. A fully insured society should also be a heavily regulated society. We have chosen social insurance with only light regulation. It may be a fatally flawed predisposition, but it has made us rich, and so we will stick with it until it is overridden by events, and evident to the vast majority. At that point, we might be open to a new social architecture.
But what would it look like? In my mind, it would restore individual responsibility in both our private and public lives. No politician, for example, would be deemed successful just because he or she had won a few elections; the new metric for political success would be a demonstrated concern for the future of society, notwithstanding the near-term costs. Our politics would be less about marketing and more about facts and reason. There would be greater recognition of the roles randomness and chance play in individual achievement. Equal opportunity, in all of its deep complexity, would be a social priority. There would also be less debt and, it follows, less income inequality. As for energy, a prudent society would spend vastly more on research and development to help prepare us for a future that, in every eventuality, requires a reliable energy supply that is not a Trojan Horse.
This appeared in the April 2013 issue.