Unconventional Economic Wisdom
Gambling with the Planet
Joseph E. Stiglitz
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DUBAI – The consequences of the Japanese earthquake – especially the ongoing crisis at the Fukushima nuclear power plant – resonate grimly for observers of the American financial crash that precipitated the Great Recession. Both events provide stark lessons about risks, and about how badly markets and societies can manage them.
Of course, in one sense, there is no comparison between the tragedy of the earthquake – which has left more than 25,000 people dead or missing – and the financial crisis, to which no such acute physical suffering can be attributed. But when it comes to the nuclear meltdown at Fukushima, there is a common theme in the two events.
Experts in both the nuclear and finance industries assured us that new technology had all but eliminated the risk of catastrophe. Events proved them wrong: not only did the risks exist, but their consequences were so enormous that they easily erased all the supposed benefits of the systems that industry leaders promoted.
Before the Great Recession, America’s economic gurus – from the head of the Federal Reserve to the titans of finance – boasted that we had learned to master risk. “Innovative” financial instruments such as derivatives and credit-default swaps enabled the distribution of risk throughout the economy. We now know that they deluded not only the rest of society, but even themselves.
These wizards of finance, it turned out, didn’t understand the intricacies of risk, let alone the dangers posed by “fat-tail distributions”– a statistical term for rare events with huge consequences, sometimes called “black swans.” Events that were supposed to happen once in a century – or even once in the lifetime of the universe – seemed to happen every ten years. Worse, not only was the frequency of these events vastly underestimated; so was the astronomical damage they would cause – something like the meltdowns that keep dogging the nuclear industry.
Research in economics and psychology helps us understand why we do such a bad job in managing these risks. We have little empirical basis for judging rare events, so it is difficult to arrive at good estimates. In such circumstances, more than wishful thinking can come into play: we might have few incentives to think hard at all. On the contrary, when others bear the costs of mistakes, the incentives favor self-delusion. A system that socializes losses and privatizes gains is doomed to mismanage risk.
Indeed, the entire financial sector was rife with agency problems and externalities. Ratings agencies had incentives to give good ratings to the high-risk securities produced by the investment banks that were paying them. Mortgage originators bore no consequences for their irresponsibility, and even those who engaged in predatory lending or created and marketed securities that were designed to lose did so in ways that insulated them from civil and criminal prosecution.
This brings us to the next question: are there other “black swan” events waiting to happen? Unfortunately, some of the really big risks that we face today are most likely not even rare events. The good news is that such risks can be controlled at little or no cost. The bad news is that doing so faces strong political opposition – for there are people who profit from the status quo.
We have seen two of the big risks in recent years, but have done little to bring them under control. By some accounts, how the last crisis was managed may have increased the risk of a future financial meltdown.
Too-big-to fail banks, and the markets in which they participate, now know that they can expect to be bailed out if they get into trouble. As a result of this “moral hazard,” these banks can borrow on favorable terms, giving them a competitive advantage based not on superior performance but on political strength. While some of the excesses in risk-taking have been curbed, predatory lending and unregulated trading in obscure over-the-counter derivatives continue. Incentive structures that encourage excess risk-taking remain virtually unchanged.
So, too, while Germany has shut down its older nuclear reactors, in the US and elsewhere, even plants that have the same flawed design as Fukushima continue to operate. The nuclear industry’s very existence is dependent on hidden public subsidies – costs borne by society in the event of nuclear disaster, as well as the costs of the still-unmanaged disposal of nuclear waste. So much for unfettered capitalism!
For the planet, there is one more risk, which, like the other two, is almost a certainty: global warming and climate change. If there were other planets to which we could move at low cost in the event of the almost certain outcome predicted by scientists, one could argue that this is a risk worth taking. But there aren’t, so it isn’t.
The costs of reducing emissions pale in comparison to the possible risks the world faces. And that is true even if we rule out the nuclear option (the costs of which were always underestimated). To be sure, coal and oil companies would suffer, and big polluting countries – like the US – would obviously pay a higher price than those with a less profligate lifestyle.
In the end, those gambling in Las Vegas lose more than they gain. As a society, we are gambling – with our big banks, with our nuclear power facilities, with our planet. As in Las Vegas, the lucky few – the bankers that put our economy at risk and the owners of energy companies that put our planet at risk – may walk off with a mint. But on average and almost certainly, we as a society, like all gamblers, will lose.
That, unfortunately, is a lesson of Japan’s disaster that we continue to ignore at our peril.
Joseph E. Stiglitz is University Professor at Columbia University and a Nobel laureate in Economics. His latest book, Freefall: Free Markets and the Sinking of the Global Economy, is available in French, German, Japanese, and Spanish.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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OrkanK 10:27 06 Apr 11
We do our best so that an airplane can fly, and we do our best for nuclear power stations. And when we compare the number of flight accidents with number of flights, we will probably find the same frequency with nuclear accidents in comparison to the number of nuclear power plants. In this way a black swan is definetely not every 5 million years, or in 500 years, but probably every 20-30 years.
The main problem in this case is, we do not consider the real cost of this risk, and also we are not considering the cost of storage of nuclear waste for the coming thousands of years. When we start calculating these future costs and the cost of Tschernobyl and Fukushima then we will have the quickest possible change of global energy system.
PaulWallbank 04:17 08 Apr 11
While I'd agree with Prof. Stiglitz that risks were not fully understood or planned for, I'd disagree that the Japanese earthquake, tsunami, nuclear disaster and particularly the Global Financial Crisis were 'black swan' events.
In the case of the Great Recession, it seems that characterising it as being unforeseeable is absolving many of those who failed to carry out their duties in managing the risks that were, and still are, building up in the international economy.
fxsarrazin 09:14 09 Apr 11
The one real change, the frightening change, that I have seen in Canada, and the USA in particular, is the broad and entrenched use, or threat of use of force.
From "eco-terrorists" getting sentences of over a decade for destroying logging trucks through crimes "created" by the Partiot Act to militarisation of police forces across the continent through the same laws to everyday people losing their jobs after being arrested at a protest (and it doesn't take much). The reason why some people are whistling away with millions while pushing the whole show closer to the edge is simply because most people just are terrified of speaking out or simply still too blind and comfortable to see the dangers their sarcastic denials are breeding.
The answer? Stop pussyfooting around these people. The energy companies paying scientist to "question" global warming "theory". Agri business destroying millions of acres of arable land. Call the bluff. They have no hand. What on earth would we do if BP became bankrupt? The risks are far far far greater if we stay quiet, and still (yes, heading off to a protest does mean getting off your chair). God, I sound like an undergrad anarchist. Everybody knows that this is the way things change.
Wasn't the deluge of B.S. we saw being parroted for years after 9/11 teach us a thing? Do you think that the "Arab Spring" will end well with us letting the State Department and the EU pulling the strings? With Camron flying off to Cairo with a delegation of arms dealers behind him?
gergrey 07:38 14 Apr 11
You completely misread the Japan accident completely! The Nuclear power stations in question were not upgraded or as reliable as a new breed would be, they are how OLD? This is where risk calculations have turned a blind eye due to economics. The trade off or minimal death counts compared to how much economic generation producing how many lives saved preserved or sustained...sounds shocking but true. There should be no residual contamination problem if this accident (no such thing as accident) had proper risk management had been implemented and designed in...AKA bigger water storage, thicker concrete on flexible bases designed to remain integral with some vibration, Generator mounted up higher etc. The materials should be captured and forced through recycling and reuse irregardless the cost and here is the problem...we want all the energy, none of the risks and a failure to pay the true costs of our climate woes. As per usual, it's a management decision and a lack of will, rose colored risk assessment problem! We need NEW Nuclear! We need Municipal Nuclear Power to replace 30-40 year old units which have served their purpose…we need to pay the piper so the weather calamities don’t swamp us economically. Can wind/solar provide that extra 80%base load? How much arsenic from the fossil fuel depot explosions did you consume in the water, veggies and air and why did we not set up detectors? Reality check…it’s always a risk issue, an economic issue>@@<
Ogonna 10:02 17 Apr 11
a gamble with no winner. we all lose. The sooner we realize this, the lesser the magnitude of our loss.
CompassionoverProfit 10:53 21 Apr 11
I can't argue with this analysis, but one important mistaken assumption makes the problems of the Climate Crisis even more insidious. Mr. Stiglitz would benefit from reading the basic literature about the expected impacts of the Climate Crisis.
Stiglitz says "big polluting countries – like the US – would obviously pay a higher price than those with a less profligate lifestyle." Not true. In fact, it is the 3rd world nations which will be paying the highest price in terms of lost land, lost agricultural productivity, and lost lives. The impacts from the Climate Crisis will disproportionately damage those nations and societies which are not only already vulnerable, but which also bear no historical responsibility for creating the crisis, and have never had an opportunity to benefit from it's causes.
Bangladesh stands to have millions displaced by lost coastline. The nations downstream from the Himalayan glacial rivers will soon have no water. The rich nations will be able to purchase their way out of the problems of increased food prices and scarcity, while those already vulnerable to food security issues will surely be thrown into war and famine. It is not the rich nations which will suffer first; our wealth will insulate us from the impacts, potentially allowing us to further stick our collective head in the sand and continue to pollute without regard for the result.
brianchoi107 08:26 04 May 11
What an insight! If Mr. Stiglitz's argument is right, however, we need to penalize those who caused all the messes, such as big investment banks, nuclear energy companies, etc. Then, we probably suffer from equally serious other problems like breakdown of financial system or energy shortage... I think that we are stuck there, and those who bailed out did so because either way was terrible and yet by choosing current option at least we can delay the problem to the future.
kellyschutt 09:34 06 Apr 11
Joe,
There is no comparison between Japan and the financial crisis. The financial crisis caused more human suffering. When CFTC regulations were lifted from futures contract volume, commodity speculation caused real food prices to reach their highest level since 1846. Approximately 250 million people were driven into starvation in '08 due to excessive commodity speculation (and biofuel programs).