When does the pursuit of safety lead us into danger? Greg Ip of the Wall Street Journal and author of Foolproof talks with EconTalk host Russ Roberts about the ideas in his book--the way we publicly and privately try to cope with risk and danger and how those choices can create unintended consequences. While much of the conversation focuses on the financial crisis of 2008, there are also discussions of football injuries, damage from natural disasters such as hurricanes, car accidents, and Herbert Hoover. Along the way, Herman Melville's insights into the mesmerizing nature of water make an appearance.
How do I listen to a podcast?
Right-click or Option-click, and select "Save Link/Target As MP3.
Readings and Links related to this podcast episode
About this week's guest:
Greg Ip's Blog
@greg_ip. Greg Ip on Twitter.
About ideas and people mentioned in this podcast episode:
Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe, by Greg Ip on Amazon.com.
Articles and Blog Posts:
"The Effects of Automobile Safety Regulation," by Sam Peltzman. Journal of Political Economy, Vol. 83, No. 4 (Aug., 1975), pp. 677-726. Jstor.
"FDR and FDIC," by Russ Roberts. Cafe Hayek. December 2008.
German and French banks got $36 billion from AIG Bailout, by Michael Mandel. Business Week blog. March 2009.
Barings collapse at 20: How rogue trader Nick Leeson broke the bank, by Jason Rodrigues. The Guardian, February 24, 2015.
Unintended Consequences, by Rob Norton. Concise Encyclopedia of Economics.
Hoover's Economic Policies, by Steven Horwitz. Concise Encyclopedia of Economics.
Insurance, by Richard Zeckhauser. Concise Encyclopedia of Economics.
Deposit Insurance, by George G. Kaufman. Concise Encyclopedia of Economics, 1st edition.
Web Pages and Other Resources:
Fallacy of composition. Wikipedia.
Derivative (finance). Wikipedia.
Sam Peltzman on the Peltzman Effect. Seatbelts and more. Youtube.com.
"Lead You to Water" Quote, from Moby Dick, by Herman Melville. Goodreads.com.
Concussion--2015 Movie Trailer. YouTube.
Peltzman on Regulation. EconTalk. November 2006.
George Selgin on Monetary Policy and the Great Recession. EconTalk. December 2015.
Velasquez-Manoff on Autoimmune Disease, Parasites, and Complexity. EconTalk. March 2014.
Adam Davidson on Hollywood and the Future of Work. EconTalk. June 2015.
Kennedy on the Great Depression and the New Deal. EconTalk. August 2010.
Terry Anderson on the Environment and Property Rights. Discussion of forest fires. EconTalk. August 2014.
Nocera on the Crisis and All the Devils Are Here. Discussion of financial derivatives. EconTalk. December 2012.
Roberts on the Crisis. Discussion of financial derivatives. EconTalk. May 2010.
Leigh Steinberg on Sports, Agents, and Athletes. Discussion of concussions and safety in football. EconTalk. March 2013.
Podcast Episode Highlights
Russ: Before introducing today's guest, I just want to remind listeners to please go to econtalk.org and in the upper left-hand corner you'll find a link to our annual listener survey, where you can vote for your favorite episodes of 2015. Please do it today. The survey will close on January 31st. So, get out there and vote!
Russ: Intro. [Recording date: December 17, 2015.] So, I want to start with an image you start off early in the book, and it's an image, a metaphor that we use often here on the program, and I'm always happy to see someone else use it. It's, I think, a fantastic idea and it is one that runs through your book, and it's very, very interesting: and that is the relationship between the financial market and its potential for crisis, and ecological systems. In particular, forest fires. So, talk about what forest fires have to do with Wall Street. Guest: I think what the environment such as our forests and our economy have in common is they are both complicated systems, so when you play with one part of it you often have unintended consequences for another part of it. If you go back and [?] what we call the Progressive Era, both the U.S. Forest Service and the Federal Reserve are both created in this period. And actually for similar reasons. In 1907 there was a severe Financial Panic, and that led to the creation of the Federal Reserve. The ideal[?] bank that could ask as lender of last resort. You wouldn't have runs on banks any longer; panics would be a thing of the past. At the same time, there were these devastating fires in the Western United States that killed many people. And the Forest Service, which was quite tiny at the time, found a new lease on life; and its mission was to put all fires out, because they viewed fires as wholly within the control of men--as the founding head of the Forest Service said at the time. All we know a century later is that neither the Federal Reserve nor the Forest Service have fully put an end to the types of chaos they were designed to get rid of. And it turns out that with these complicated systems, simply trying to take steps to prevent or end disaster will sometimes cause offsetting effects that actually make disaster more likely. And that's a theme that runs through my book. And the key to Federal Reserve, by making recessions less frequent and less severe, they actually encouraged the buildup of debt and other types of risk-taking. And in the case of the Forest Service, when they actually repeatedly suppressed forests, they allowed more fuel to accumulate on the forest floor; and they allowed to become denser. And this means that when fires do get started, they become fiercer and hotter, and more destructive. Russ: And we talked about this recently in an episode with George Selgin. And in particular we talked about the forest fire/financial market analogy. And one of the implications is, as you say with forest fires, that the fires that do break out will eventually become so severe that that they are very, very hard to put out. So the damage becomes much greater in terms of just acreage and ferocity. The implication for the financial sector is that as we try to dampen the swings in the economy, that the crises will get worse. Or I guess a more accurate way to say it is: If we could create a Great Moderation that would last 50 years, one of the predictions of this idea is that the thing that would end it would be horrific rather than just unpleasant. Guest: I think--yeah, I think that's right. Now, obviously we don't have Depressions often enough that we can run a rigorous statistical regression on this thing, so I wouldn't want to make heroic[?] forecasts about what will happen if we have another 15- or 20-year Great Moderation. But I think the intuition is there. And the information that I dug up while I was researching my book I think made a pretty convincing case. And it's not simply a matter of what our government authorities do. For example, one way of looking at this is by preventing recessions and periodically rescuing banks that are about to fail, aren't you creating moral hazard? And therefore just encouraging people to take more risks? That is true as far as it goes. But the story is actually a bit more complicated because in some sense, preventing recessions is what Central Banks were supposed to do. And people naturally respond to that by saying, 'I'm going to do more of the investing and hiring and the good stuff that makes us want people do to, that makes us prosperous.' Secondly, a lot of the actions are taken by people themselves. And so for example, banks--in the financial system, when we had so many banks teetering on collapse, our regulators actually took steps to make the banks safer by making them hold more capital. But better-capitalized banks turned out to be less profitable banks. And so some of the lending activity that they used to do migrated out to the capital markets. It migrated out to companies that we now call Shadow Banks. Russ: Yep. Guest: And less regulated, free-wheeling sort of finance. The other thing that went on is you had the financial engineers coming up with hedging instruments--derivatives--that were meant to reduce the risk for a bank to considering buying a particular security, or making a loan. And so this increased their appetite for risk-taking--not because they were deliberately trying to take risks but because they thought they had something that made them safer. That's kind of the paradox at the center of this book. Russ: Yeah, and I love that. I love this idea that--I don't love it; I love the intellectual concept, though--that this idea that as things get safer and safer, it's not just--your book has many, many interesting stories and applications, [?] ideas. You go beyond I think what the standard treatment is. I went into the book with a little bit of trepidation because I've interviewed a lot of people and read about and thought a lot about these issues. But I learned a lot from the book anyway. Which was a happy surprise. And I recommend it a lot to our listeners who are interested in these issues. I think you try to make some connections that are often missed.
Russ: So, the standard story is: Things get safe or[?] people get lulled into a false sense of security. For example. And that's part of it. But you are really trying to say something deeper about the nature of risk, and safety in particular, when it is systemic--when it extends across an entire market or the globe, and how the desire we have for safety, the desire we have for risk, inevitably pushes us to seek out instruments that--investments and techniques that make our life less dangerous. And often they are scarce. And so, as a result, there aren't enough to go around. And as a result the system is more dangerous than it appears. Is that an accurate summary of that overarching principle? Guest: Yeah. You've touched on some of the key issues that I think I've touched on here. For example, I talk in my book about the Fallacy of Composition--doing something makes one person safe and if everybody does it they are all safer. But we know that's not really true. Now just take the most basic example of Fallacy of Composition. You are watching a movie; you stand up to see it better. If nobody stands up, nobody sees it better; and eventually your feet start to hurt. And there's something that goes I think in these systemic events. Think about building levies to protect a [?] neighborhood or part of a town or city from a flood. Well, even if the levee holds, it's effect really isn't to get rid of the flood water, to push it, but to push it elsewhere. So, sometimes protecting one city from a flood simply pushes the water upstream or downstream and puts another city at greater risk of flood. We saw that with these epic floods in Thailand, for example, a few years ago, where in Bangkok there were like huge fights breaking over whose neighborhood was going to flood, or whose levies were going to be torn down. In the financial market something similar goes on. So, to go back to my example of the derivative: The financial engineers who designed the derivative said this does not get rid of risk. It transfers risk. Okay? I'm Bank A; I buy this derivative. I'm now protected from the risk if this loan goes wrong. The person who sustains that damage if the loan goes wrong is Bank B who has sold me that derivative. In theory the derivative is supposed to redistribute risk from those who don't want it to those who do want it. But what if everybody does the same thing, and everybody individually buys a derivative from everybody else? Each person thinks they are protected. But in fact everybody has bought protection, which means that nobody is protected, because everybody is exposed to the decline. Somebody told me as I was researching this book, it's as if you were buying insurance on the Titanic from somebody else who is on the Titanic. And I think we have an element of that in our financial system. Now, in the insurance industry, insurance companies are happy to sell you life insurance because not everybody dies at the same time. The risks of the insured are essentially not correlated. But with systemic events like financial crises or earthquakes, correlations are very high. It is very likely that if Bank A fails then the events that cause it to fail could also threaten the life of Bank B. So if Bank A bought protection from Bank B, they are not really protected. And that's what we saw in the Financial Crisis: A lot of banks thought they were protected because they bought insurance from AIG (American International Group) against the default of their prime investments. But it turns out that once enough banks did that, AIG's own existence was threatened because it had sold too much insurance, as it were, against this earthquake. Russ: I was going to talk about AIG later, but while we're on the subject, let's talk about it now. And I think your treatment of the issues surrounding AIG and the Financial Crisis generally are some of my favorites. Maybe the best I've read, and I've read quite a bit on the Crisis. I do have one thing I disagree with; we'll come to that. But just in terms of the pure clarity of your description, there's a lot of detail and insight in the way you discuss it. So, the AIG bailout--the creditors of AIG, the people who were owed payments, people, the institutions mostly--were very large. And they had large amounts of money that they were expecting from AIG. The equivalent of insurance payments. And so I often describe the bailout of AIG as a bailout of Goldman Sachs. It's a bailout of, I think it was Societe Generale, the French Bank. Deutsche Bank was in the top five. So a bunch of large financial institutions were the main beneficiaries of the government bailout: the money that the government provided to AIG--AIG was a conduit, really. But as you point out--and I think it should have been kind of obvious--people should have been aware when they bought that insurance that if everybody bought it and they were all insuring against the same thing, well then the question was: Was AIG reliable and likely to pay off? And: How much backstop did they have? It's a great thing you have in your book, which I love, is when you talk about the fact that Goldman, when confronted with this claim that it was it really a bailout of Goldman, they, 'Oh, no, no, no. We're smarter than that. We had insurance. Even on AIG: we were doubly insured.' That's not quite true. So explain why not. Guest: Well, because--you're right. Goldman Sachs is an interesting kind of company because they were bearish on the subprime market before anybody else and they were one of the few that was not holding large amounts of exposure when the roof fell in, in 2008. One of the reasons why is because they actually bought these insurance policies from people like AIG that would go up in value as the subprime market went down. Well, then the question came up: What if the insurance companies who had sold them these policies went bankrupt, like AIG? And you said[?], their claim was: We would have been fine because we bought insurance against AIG failing. But if you look at who they bought that insurance from, they bought it from people like Lehman--who did fail, and Citigroup, who would have failed had the government not bailed them out. And the point that I'm making here is that--you have to understand the difference between a bank failure and a systemic crisis. Sometimes a bank can fail because the things that affect it are very idiosyncratic. Think about Barings, for example, that went under because one of its traders ran up a billion dollars in losses. In a systemic event, everybody--the good, the bad, the middle ground--are all being sucked under. And Goldman Sachs, everybody around it was going under. The lesson[?] here is that no system can insure itself. And that is why the role of the Federal government as the insurer of last resort is so important in that event, at times like that.
Russ: Okay. I want to push back on that in a minute. But first I want to point out is that one way to think about your point about AIG is that what Goldman needed to get insurance from is like a Martian Bank, where there was no housing crisis. He needed to go outside the system. And there is eventually nothing outside the system. And I think, again-- Guest: Right away, Russ, knowing Goldman, I'm sure that they looked into it. Russ: Yes they did. And possibly, after seeing the Martian they were fooled into thinking it really was a possibility. But I want to talk about the role of government. And there are many roles that are played, in the last 25, 30 years in potentially increasing moral hazard; and I'm a big advocate of that as part of the problem and not part of the solution. But you are right. At some level, the government, especially the U.S. government in the story we are talking about, was the backstop. Was the insurer of last resort. And I would argue--and you are not unaware of this argument--I would argue that that is the source of the problem. Not the solution. At any one time it looks like the solution, because things are falling apart. But I would argue that since there are so many interconnections that are there, that makes the argument be it has got to be the government. Because it's systemic. But isn't it also equally possible that those systemic relations would never persist if people were really--if it was a credible argument, belief, that the government would not bail people out? Isn't the very--the blindness, the myopia about that systemic risk--isn't that fundamentally a view saying, 'Well, I don't have to worry about the systemic risk, because there's always Uncle Sam who will step in?' And wouldn't those risks be more--wouldn't investors and institutions be more aware of systemic risk if there was not a bailout of last resort? Guest: Russ, at some level that must be true. I mean, it must be true that the fact that people know that the Federal government can be there to save us has got to be a factor in [?]. A very simple example is deposit insurance: it was created in the 1930s to prevent runs on banks. And FDR (Franklin Delano Roosevelt) was at first very reluctant to sign that into law-- Russ: He opposed it. Guest: He did. Russ: He had mocked it as a candidate when he was running for President. Guest: Right. And yeah. Russ: When he was Governor--sorry. When he was Governor of New York. Guest: Oh, is that right? Your history on that is better than mine, Russ. Russ: We'll put a link up to it. I've got a little write-up of that. Guest: So, he legitimately worried that Federal Deposit Insurance would weaken the oversight that depositors themselves are supposed to bring to the banks that held their money. And so the answer was: If you are going to have deposit insurance then you have to regulate these banks much more tightly. And so in some sense, yes, we created an externality, a market failure, by introducing deposit insurance. But we also tried to address that with proper regulation. You get into much more trouble when you create this externality but you also do not create the regulation. In the case of the most recent event, the most obvious example would be Fannie Mae and Freddie Mac. These were essentially private shareholder companies that had implicit shareholder guarantees for their borrowing. And that advantageous cost of capital enabled them to take much larger positions in the mortgage market than were good for them. And they were certainly contributors for the financial crisis that we had. That said, I don't think that's the full story or even most of the story. Because one of the things that I became convinced about as I read[?] this book is that human memories are not long enough to fully incorporate all the experience of the past. In over a 25-year Great Moderation, it was hard for me to believe that people could remember what had happened like in the 1970s and the early 1980s and that had affected how they were deciding what to do. And in fact there were instances--and this is fascinating because it goes to my point about how risk evolves--of Wall Street behaving specifically to get around the safety net. So, for example, if you are a bank that accepts deposits, you have to actually pay insurance premiums on those deposits. You also have to, like, submit to bank regulation. And that's one of the reasons this money migrated to places where none of those things were true--into Money Market Mutual Funds, which were originally designed to get around rules over banks and into so-called asset-backed commercial paper conduits. And I don't want to blow the heads up of anybody listening by getting into some of this esoterica. But to go to an example from the environment: There is some interesting research on how people respond to floods. Hurricanes, you would think, come often enough that people would always incorporate the risk of being hit by a hurricane into their decisions. And they do. This research has found that people, after a hurricane, they rush in and buy flood insurance. And they also build their houses better. Research has found that homes built right after a hurricane survive the next hurricane much better. Isn't that interesting? But the problem is that after a few years after that hurricane, people begin to forget. And because the memories are less vivid, that begins to change. Their behavior--they drop their flood insurance policies. They stop building their homes as strongly as they did. And even in the situations where that economic incentive is to do it properly, where they are penalized by their flood insurance, it turns out that human memories simply are not long enough to apply the appropriate weights to events that happened long ago to their behavior going forward. And this is why the risks are so great, the longer you go without an event. Russ: Well, it cuts both ways. As you point out as well in the book. Right after a hurricane people might tend to over-react about how risky a hurricane is. Maybe about 25 years or 50 or whatever it is, people start to think, 'Well, it will never happen to me,' or 'It won't happen here,' or they just literally forget or are unaware of it.
Russ: But I want to come back to the point you made about the FDIC (Federal Deposit Insurance Corporation) and regulation that FDR felt was necessary. And I haven't quoted this in a long time: long-time listeners are going to be happy hearing me quoting Hayek, my favorite Hayek quote, which is: The curious task of economics is to demonstrate to men how little they know about what they imagine they can design. So, you start off: You have FDIC insurance. And you think that, if I do that, I'll--if banks know that they are going to be bailed out, and if customers know that the banks are going to be bailed out, then we'd better restrict what kind of interest rates banks can offer. And similarly, once we say we're going to bail out large financial institutions, we are going to have rules about leverage. We are going to say there's a certain cushion you have to keep. And you might argue: 'Well, but don't they want to do that anyway, to encourage confidence and trust from people who give them their money?' And the answer is: Well, normally they would. But if people know that the government can step in, they don't have to do that. And so, naturally, the government then requires it. So, in one sense, a lot of the Crisis can be described as the relentless attempt by financial institutions to exploit their government guarantee despite--despite--the regulations put in place to reduce the likelihood of [?] to raise the price of misbehavior. So, sure: you had to invest, you had to hold a lot of Triple-A assets. But as you point out in the book, they are scarce. And as you point out in the book, they found creative ways to create what looked like Triple-A assets that turned out not to be Triple-A assets. So it is a--I take your point that it's an inevitable tradeoff of security versus risk-taking that makes--it makes an argument for the government as the insurer of last resort. But you do have to confront the fact that as a result you create a system that is actually inherently fragile. Inherently almost--it's almost impossible to avoid another crisis. And I think your title of your book is key: Foolproof. Foolproof is a mistake. We shouldn't be shooting for foolproof. We should be shooting for something where the costs of a failure are small relative to the potential disaster. And I think our policy with respect to financial institutions has failed that criterion. Guest: You know, yeah, I think I might have a difference of opinion about exactly just how important that government guarantee was with respect to the Crisis. Russ: Yeah. Lay it on me. Guest: Well, I think that what I thought was interesting was the extent to which the private sector tried to develop devices of their own where they thought the government safety net was actually unnecessary because they are brilliant at designing things that were supposed to be Triple-A. A little while ago I saw the movie, The Big Short, which is in theaters now reliving all the craziness, insanity of the financial crisis, and the derivatives that were created. And it has the familiar narrative that these Wall Street guys were deliberately taking big risks. But what I think--and it's an [?] story and for sure that was part of it. But what I think it's not including in that story is the extent to which these Wall Street guys honestly thought that what they were doing wasn't that risky. They thought that a Double-A- or Triple-A-rated security had so much protection through various ways, there's just no way this thing could blow up. And I would say that, in terms of going forward, one of the challenges we as the public and citizens and our government is: How do you create a financial system, how do you create an economy that both gives us the safety that we need to both be happy and to prosper and to take risks without destroying our selves but doesn't create those fatal levels of complacency? And there has to be some kind of tradeoff between these kind of things that we are talking about. I don't want to take away the ability of the Federal Reserve to basically move in as lender of the last resort when things really are grim. But nor do I want those powers being used for every garden variety crisis that comes along. There's got to be a way to allow even the largest banks to fail--or whatever our legal definition of failure is for something like that--and the knowledge that that can happen will change the behavior both of the bankers and the people who are lending money to those banks.
Russ: So, let me push back and give you a chance to respond. It's certainly true that some of the people involved--maybe a lot of them at the height of the run-up to the Crisis--were blissfully unaware. They were dancing on the Titanic, they were waltzing while the band played and were blissfully unaware that a large iceberg was looming. I accept that. What I think the next question is: If we had allowed them to suffer the financial pain--which of course many Americans did, but not as many on Wall Street--if we had made the decision-makers suffer through some of the serious costs--that is, wiping them out. Instead of Bear Stearns' creditors' being made whole, they had paid a serious price, and maybe lost almost everything, as we did with Lehman a few months later. If that had happened, well, it would have been bad; certainly it would have been bad for the people who had to deal with it. And it would have created a really big side post and lesson. Now it's true, and memories are short; but I think if it's really awful, the memories tend to last longer. And for people spending large sums of money, they have an incentive to pay attention. So, my problem is, is that if you are always--if you promise that you'll always be hovering over the Titanic with a new set of lifeboats, they will drive less carefully. And that's bad policy for the taxpayer. It's a bad policy for capitalism. It's a bad policy for democracy. Because we see these folks being bailed out. And it's true that some of them lost a lot of money. But even after that, most of them did pretty well. Guest: Um, you might be right. This is in the category of historical what-ifs that we'll never get a chance to run. And at some level, would allowing Bear Stearns to have failed in the Spring of '98 [?2008] made the subsequent failures less bad? Russ: You are talking about--you mean LCTM [Long Term Capital Management]. You said "'98". Guest: Oh, I'm sorry. I meant 2008. Russ: But there was also a 1998--there were a lot of them. You write about most of them. You write about the 1998; you write about the--you didn't spend much time on the 1994 Mexican bailout. But you did refer to it earlier when I wasn't as much--I didn't know much about. Guest: Yeah. Russ: And the one--by the way, my other example, I think, which I've used and which you referenced very thoughtfully is the Reserve Primary, the Money Market Fund that broke the bank [broke the buck--Econlib Ed.], that many would argue was a really precipitating--I would argue was really the scariest moment, probably, in the halls of Washington and the Federal Reserve when it looked like money market funds were going to be at risk of a run. And what the heck were they doing holding $785--I'm reading this straight from your book--of short term debt from Lehman Brothers? Guest: Yeah. Russ: And the answer is, because they'd just seen Bear Stearns, which had a very similar balance sheet, do okay. Guest: Yeah. Russ: So they thought: Hey, I can get a good return. Let's go for it. Guest: Yeah. Yeah, I think that's probably the best example you can find, actually, of how the rescue of Bear Stearns actually caused some people to take, to be oblivious to the possibility that this would spread to other firms. Because this would actually accompany--the reserve fund--actually, I'd like to step back a minute and just talk about how money funds got started in the first place. The Money Market Mutual Fund is at its essence a form of regulatory arbitrage. In the 1970s banks were regulated in the interest rates they could pay deposits. But if you were a big institutional investor you could get better rates by investing in wholesale money markets. So the Money Market Mutual Fund was invented essentially to create a pool of these types of higher-yielding investments that ordinary retail investors could access. And they were designed to be as safe as bank deposits: So, they would only hold government paper or bank-guaranteed Certificates of Deposit. But you know, as the 2000s evolved, competition being what it is, and reach per yield being what it is, Reserve Fund [Reserve Primary Fund?], which was the grand-daddy of these funds, began buying other types of riskier stuff. Commercial paper. And as you move into the financial crisis period, they are owning paper by Merrill Lynch and Lehman Brothers and Bear Stearns. And in the aftermath you have to ask: What were they thinking? Why were they holding this stuff? At some element perhaps they were assuming they wouldn't fail. But on the other hand, the rating agencies were assuming something similar, because these had very highly rated paper. And indeed, the Friday before Lehman's failed, that paper, Lehman's paper itself was rated top notch. So perhaps at some level the rating agencies had come to that same assumption, that it would not be allowed to fail. But here's what I sort of think is interesting about Reserve Fund. You are absolutely right. I remember the Fed officials saying that of all the scenarios they went through the weekend before Lehman went bankrupt, the one bad part that they really did not take on board was that a money market fund would break the buck. Russ: Right. Guest: And the consequences went well beyond that $700 million-odd dollars that [?] Lehman paper [?] Russ: Which as you point out was a small part of their--it was a very, very small, under 2% of their portfolio. Guest: But, yeah, the risks, and this is kind of what a panic is like. And in my book I talk about how this is similar to when somebody dies from e-coli from on their spinach or their tomatoes: You know that means people swear the stuff off from coast to coast. And similarly here, when people realized the world's oldest money market fund could be holding toxic stuff, money just poured out of all the funds just like that. And because these funds had become such important sources of lending to the financial system, this was in some way possibly more serious than Lehman's failure. Russ: Right. Guest: And so, once again, you have the assumption of safety that's allowed to spring up around a particular entity creating risks or complacency that then just explodes. And one of the things that's ironic is that when all was said and done, as we were discussing, the Reserve Fund still paid back a little over 99 cents on the dollar. Lehman was its only losing position. And Gary Gorton, who we could talk about, an economist who specializes in the history of panics, has gone back and looked at bank panics in the 1800s. And the worst bank failures at those times, those banks still managed to pay back all but 2 cents on the dollar of their deposits. So, I find it interesting that the 19th century and 21st century of a bank run had essentially the same outcome: which is that most of the depositors got their money back; but the panic by people in the moment was incredibly destructive.
Russ: The other part that's destructive--you only talk about this in passing but you mentioned it earlier in our conversation today--the other part that's destructive that's much harder to see is the poor use of scarce capital. So, it's not just that some investors lose their money in a bank run--and your point is correct that maybe it's not as bad as it looks. The psychological ramifications are what create this implication of panic. If you told them in advance, 'Hey, you might lose 2%,' you might say, 'Well, that's not so bad. I'm not going to panic about that.' And you get all the good stuff along the way. My problem is: Some of the good stuff is not good. So, to devote a trillion dollars to new and larger houses is really a bad allocation of scarce capital. And I really deeply resent this view that says, 'The financial sector is doing God's work.' I think that's a quote from Lloyd Blankfein. Because they are allocating capital to its highest use. Well, it's highest use is true when the incentives are right. When the incentives are wrong, it's not its highest use; and we end up throwing away a lot of potential growth that looks like growth when it's happening. So the boom, which looks like the benefit side, is actually not as beneficial as it looks the measured boom--a lot of growth in housing and economic activity but the true value of it is as high as it otherwise would be. So I think that's part of the issue. Guest: Yes. Now, let me touch on something in my book that I think addresses this question, which is the nature of the risks that we take. And I think that at some level, and I think people especially who are more inclined to have the government play a more active role, feel that the goal of society and of government should be to encourage us to take good risks that can produce all sorts of wonderful innovations and not bad risks that can produce things like financial crises. But what I concluded after researching my book was that that's really kind of just impossible. It's fantasy, that we can somehow distinguish ex ante what are the good risks and what are the bad risks. And in that book I talk about this interesting experiment that some economists and neuroscientists did with people who had brain damage. And these people, the damage to their brain means that they don't feel an emotional sense of fear when bad things happen. So, when they are encouraged to play a card game which is a losing card game, they keep on playing until they've lost their money. Whereas normal people, the sense of fear interferes and they stop playing. And this seems to tell you, though: Well, this shows that unless you have a normal sense of fear you end up really hurting yourself. But then an economist actually re-ran the experiment using a different game that actually was a winning game, not a losing game--it was actually designed to pay off. And they found that this time, if the people whose brains didn't allow them to feel fear end up ahead in the game, then the other people ended up behind. Russ: They kept playing. Guest: They kept playing, yeah. Whereas the people who had normal brains, as soon as they lost money, they stopped playing. And I use this as kind of an allegory for capitalism in general, because there is a lot of risks that people take which ex ante don't make any sense. Like opening a restaurant. Russ: Correct. Guest: Like, most restaurants fail. Why would anybody open a restaurant? Well, thank goodness their brain does. Russ: They are brain-damaged, obviously. Guest: Maybe, yeah. Russ: That's the deduction. Guest: We all know somebody like this, you know, who takes a chance like this. Some of them end up losing their shirts, but some of them end up showing up at your high school reunion in 20 years' time really wealthy. And boy, I wish I were lucky. But you've got to hand it to them: they took that risk. Most of those people who started restaurants lost money, but one of them ended up starting McDonalds. One of them ended up starting Starbucks. And we want that to happen. And we don't know in advance the ones that are going to succeed and the ones that are going to fail. And at a larger level I completely agree that it's a terrible tradeoff to run these risks and borrow all this money to build houses that ended up not being lived in. But on the other hand, I can remember 15 years ago when people had the same concerns about the NASDAQ (National Association of Securities Dealers Automated Quotations) Bubble and the Tech Bubble; and a lot of things did come about as a result of that bubble. I'm not sure that I want somebody telling me or society as a whole, 'It's okay to take these risks but it's not okay to take those risks.' Because I don't think anyone knows in advance which are the risks that are going to pay off. And I would say one of the things that troubles me a bit in the last 7 years is that I think[?] the pendulum has swung from being too far toward taking risks to taking too little risk. If you look at what companies are doing these days, they are not heavily investing-- Russ: Sitting on their money Guest: in new products. Yeah, sitting on their money. They are buying back stock. They are merging with each other. Banks have been so heavily regulated or so threatened[?] by lawsuits or losses that they don't want to lend to small businesses. People who might be good homeowners can't get credit because the pendulum has swung too far away. So I think, one of the things I've been trying to say in my book is that we need to be adults about risk; is that we cannot have a system that gets rid of all possibility of disaster and crisis. Because if we do that, we'll end up without some of the positive things that come from risk-taking, whether it's investing in startup companies or building cities on the coastline where they might be hit by a hurricane. Russ: Yeah. I totally agree with you that there are many beneficial things that come from risk. Maybe our difference is that I'm much less enthusiastic about great moderations that come from the sense that risk-taking is okay because the government is going to rescue us. The NASDAQ Bubble was--to the extent it was a bubble: I don't like that word so much--but to the extent that there were a lot of companies that tried new things and some of them didn't work, and some of them did: the only people who propped that up artificially were the investors. The investors in Amazon--Amazon might not have made it. It turned out, it seems to have made it. It's not 100% clear. I think it's a profitable company. But for a long time that was very much in doubt. And my view was: God bless Jeff Bezos and all the people who put money into it. I'm getting relatively inexpensive books in a very short period of time, and it's wonderful. And that was the benefit. Even if they hadn't made it. But if they didn't make it, the people who would have paid the price would have been those investors. They would have learned a lesson. And the tragedy, I think, of our current situation is that people who are learning the lesson unfortunately are you and me, the taxpayers. And we don't see that lesson so clearly. A lot of people are angry that the banks made a lot of money. I'm not sure they see these connections that we're talking about. And the political market doesn't work quite as well as we might like. So, what's the probability that it will keep happening? It's pretty high, I'm afraid.
Guest: Yeah. Well, I wish I had the perfect answer to this. I don't. But maybe I could just bring up a couple of other points here. Because we've talked a lot about the financial system, and one of the things I was exploring as I researched this book was how the larger macro forces that you and I have been talking about manifest themselves at a micro level too. Russ: Perfect. Perfect segue. Guest: Yeah, it seems [?] is like playing football. [?] Or driving your car. Russ: That's where I was headed. So let's actually talk about the Peltzman effect. Sam Peltzman has been a guest on the program. Let's talk about traffic deaths and the challenges of making cars safe. Guest: I remember you saying, telling me earlier, that Sam was one of your teachers. A colleague of yours? Russ: I was his TA. (Teaching Assistant). He was my professor and I was his TA. And trust me, he dressed just as flamboyantly in 1978 as he does now. Maybe a little more. Because the stores he used to shop in, I think he's told me that a lot of them don't exist any more. So he struggles to keep his wardrobe up to date in its flamboyance. Guest: Yeah, so for listeners who aren't able to visualize this--so I show up, and here's Sam Peltzman, this famous, irascible, sort of anti-establishment economist and he's wearing this like, if I recall, a fuchsia-colored jacket and checked plaid pants. Russ: Yep. Sometimes they are lime green. He's very colorful. Love it. Black shirt, could be a black shirt with that outfit. Guest: He told me that he was a contrarian from childhood: that as a kid on his street in Bensonhurst, he was the only person he knew who was for Truman. So, Peltzman in true contrarian fashion, in the 1970s--well, going back to the 1960s--for the first time there's Federal regulation of automobiles. And this requires for example the installation of safety belts. In the 1970s, some jurisdictions go a step further and they require the wearing of safety belts. So what Sam wanted to know was: Does wearing seatbelts actually change the behavior of people who drive the cars? And his hypothesis was that if people felt safer they would drive faster. Because if you think of the risk of an accident as part of the price of driving fast, then if you lower that price--make the risk smaller--you should do more of it. And this is what his early research found: that the presence of seatbelts and other safety devices seemed to encourage drivers to go faster, and more--while drivers were less likely to die, you had more pedestrian accidents. And this was, as you can imagine, a pretty radical and surprising finding. Russ: Controversial. Guest: Very, very controversial. Russ: People didn't like it. Guest: And we've seen people explore elements of that in other walks of life, such as sports. Now, it turns out that once you do lots and lots of research--and Sam himself points this out--is that the pure Peltzman effect in the sense that cars are less safe with seatbelts is not true. It does turn out that you get fewer deaths with seatbelts than without. However, the effects are not as positive as the designers expected. Russ: There's an offset. Guest: There does seem to be an offset. And I think one of our jobs, when we try and evaluate these things, Russ, is to find out whether that offset, how big that offset is. Is it just small, in which case go ahead? Or is it quite large--does it completely negate that improvement? So, a good example of this is Drivers Education [Drivers Ed]. The assumption since the 1930s is that if you had your kid take Drivers Ed, he'd be less likely to have accidents and drive more safely. Well, it turns out that's not true: driver's education does not seem to reduce accidents among young drivers. In fact, because it enables young drivers to get their license sooner, you actually get more accidents. Why? It just happens to be that young drivers, they think they are immortal; and it's very hard to change their attitudes toward risk, even with drivers' education. Anti-lock brakes are another interesting example. They were thought to be the most miraculous safety innovation to come along since seatbelts. But the research is pretty conclusive that anti-lock brakes do not reduce accidents. And when you study the behavior of people with anti-lock brakes, you find that often they seem to be driving differently. In some instances, for example, they brake harder. The result: Fewer front-end collisions, more rear-end collisions. One of the most interesting insights I gained while I was working on this book is that one of the things that determines whether a safety innovation makes us safer or not is: How does it actually affect our tasks? Seatbelts, most people nowadays don't even think about seatbelts. They put them on; they forget they are wearing them. It doesn't really affect what they do from second to second. But, with things like anti-lock brakes or other types of devices, it actually does seem to affect what people do, the way they drive. They think, 'Oh, I've got those anti-lock brakes, I've got those roll bars, I've got whatever. Or snow tires. I've got better control; I've got braking. I'm going to drive faster.' And I make this same analogy to financial derivatives. Derivatives make the bank or whoever is using it believe they can now do something that they couldn't do before. They can take a larger position. They can make a bigger bet. Because they've used the derivative to protect themselves. Russ: They are wearing seatbelts. Guest: No, they are using anti-lock brakes. Russ: It's even worse. Guest: Yeah, yeah.
Russ: I thought that was a fantastic subtlety. Even though I'm a big fan of Sam's, and I'm sympathetic to the seatbelt hypothesis, I think the idea that there are some forms of safety that are more salient, that you are more aware of--because you are using the brakes all the time and you don't really feel the seatbelt all the time: it's an interesting psychological effect that might make a difference between the two cases. Guest: Yeah. And the example of football helmets I think is especially relevant here. A hundred years ago people didn't wear helmets; and people often died playing football. Roosevelt [President Theodore Roosevelt] at one point called all the heads of the universities in and read them the riot act: it's got to stop. By the 1940s, leather helmets that the players were wearing were being replaced by hard helmets, which provided much more protection. The coaches also realized that because their players' heads were so well protected, they could now use their head to spear opposing players. The defensive player was a much more formidable player than one just using his arms. But this actually [?] different risk, which was: Put your head down, you load all this pressure on your spinal column. So as players began using their heads as battering rams, you had a surge in the number of broken necks and quadriplegias. So, a perfect example of how the presence of a safety device changed the behavior of the person using it. Eventually both the NCAA (National Collegiate Athletic Association) and the NFL (National Football League) outlawed spearing because they realized this was a problem. But they have not fully been able to attenuate the effect on the players' behavior of having these helmets. And the leading cause of concussions in the NFL these days is helmet-to-helmet hits. They have, despite all the efforts to educate all the players and to change the rules to make certain hits legal and to essentially penalize that behavior, they are still getting a lot of helmet-to-helmet hits, and a lot of concussions. Russ: Yeah. One of the challenges there, as any football fan will know--and we see this every single week--when there is a collision, watching it in real time which is what the referees have to do to call a penalty--and then watching it in slow motion is very different. And the referees have to call the penalties in real time. And it's not so easy to say, 'I'm not going to tackle with my head; I'm going to use my shoulder.' It's a gray continuum. So, one of the obvious solutions, which of course you mention is: Let's get rid of the helmets. That would certainly--then, just like those brakes we're always being, reminding you, falsely encouraging you to be reckless, not wearing the helmet would definitely encourage you to be careful. Guest: Yeah. I asked a neurosurgeon about this, and he said, 'Yeah, if you got rid of the helmets you'd have fewer concussions but you'd probably have more skull fractures.' The truth is, I don't know. I do know that if you look at rugby, where they are not permitted to wear hard helmets, they do seem to have fewer head injuries and far fewer concussions. But the thing that--you have to step back and realize-- Russ: Less entertaining. It's a less entertaining and popular game. Guest: It's a less entertaining--it is a different game. And so one of the points that I make in my book is you have to account for the fact that people have certain appetites for risk. People who go to watch football want to see a really hard-hitting game. That--you know, the possibility of injury, I hate to say it, is one of the things that makes the game exciting, because it's associated with just how fiercely those players go at each other. Russ: The speed. The size. Guest: And the players themselves believe the same thing. For a long time Monday night football had a picture of two helmets colliding and shattering with a lightning bolt coming from them. I think that just speaks to the kind of spectacle. People come to see a football game, not a rugby game. And by the sports, each year the players get bigger, because bigger players are stronger; they are faster; they hit each other harder. That's what thrills people. It's what they want to see. Russ: Yeah. There's no doubt about it. I think the key question for me--and it's not the way everybody would view it, of course--but the way I view it as there's a big difference between making a decision to be a football player in ignorance versus knowledge. And I think the tragedy of football--and I haven't seen it yet but there's a new movie out called Concussion with Will Smith, coming out I think in a week--the tragedy is everybody understood that football is a dangerous game. Obviously. I don't think they understood just how dangerous it was. Now we do know that. We know something about it. We don't know everything. But as a result, a lot of parents, and some of them are football players, are saying, 'I want my kid to be something else. I have a wonderful athletic ability, and it could be used elsewhere. I want my kid to play soccer or baseball. Basketball. They are profitable. They are wonderful, lucrative opportunities for kids who are in the top half of a half of a half of a percent. And why risk it with football?' Yet, there are other people who say, 'I love football. I'll take a chance. It's not a certainty.' I think if it were certain that after 8 years, 10 years as an NFL player you would have brain damage, that the sport would disappear. And I think it's at some risk of disappearing if they don't find a way to reduce this risk. They've made a step now, right? [more to come, 47:40]