Now that the economic meltdown of 2007-2009 is starting to shrink away in our rear-view mirror, all the talk through the US, the EU, the G20, and various other camps is centered on “bank reform”. Whether we’re talking about new taxes on them, regulation around capital limits, compensation caps or the like, we’re still only talking about the banks and regulating their “performance”. While I certainly don’t disagree with the concept of reforming the banks, I think we aren’t looking holistically enough at what is really going on. We need “business reform”, not (just) bank reform.
Recently, Harvard economist Kenneth Rogoff contributed this short article comparing the BP disaster that is currently playing out in the Gulf with the economic meltdown. His main argument is that a common element in both disasters was the degree of risk willingly undertaken by market participants in deploying new “innovations” in their business models. In the economic meltdown the innovations were sophisticated financial instruments; in the BP case it is the engineering innovation of drilling 1 mile below the surface of the Gulf. Rogoff states:
“Economics teaches us that when there is huge uncertainty about catastrophic risks, it is dangerous to rely too much on the price mechanism to get incentives right. Unfortunately, economists know much less about how to adapt regulation over time to complex systems with constantly evolving risks, much less how to design regulatory resilient institutions. Until these problems are better understood, we may be doomed to a world of regulation that perpetually overshoots or undershoots its goals. The finance industry already is warning that new regulation may overshoot – that is, have the unintended effect of sharply impeding growth. Now, we may soon face the same concerns over energy policy, and not just for oil.”
An underlying concept of the Business Detox Project is that one of the main reasons why we keep “getting it wrong” is that the pricing signals that we send to business are incomplete and significantly understated. It’s that well known matter of “externalities” that we haven’t yet built into our pricing regimes. This perspective is forcefully put forward by Guardian columnist George Monbiot in this blog entry:
“Pollution has been defined as a resource in the wrong place. That’s also a pretty good description of the company’s profits. The great plumes of money that have been bursting out of the company’s accounts every year are not BP’s to give away. They consist, in part or in whole, of the externalised costs the company has failed to pay, and which the rest of society must carry. Does this sound familiar? In the ten years preceding the crash, the banks posted and disposed of stupendous profits. When their risky ventures failed, they discovered that they hadn’t made sufficient provision against future costs, and had to go begging from the state. They had classified their annual surplus as profit and given it to their investors and staff long before it was safe to do so.”
What this all really comes down to an understanding of the risk profile that society is willing to put up with in our market-based system, and how much latitude we are willing to provide to businesses to “manage risk” on our behalf. If we dramatically underestimate that risk (either through legitimate ignorance or willful negligence) we will in turn provide pricing signals that serve to minimize risk mitigation strategies and overstate profit opportunities. In turn, when bad things then happen, those companies have very strong incentives to approach the state looking for financial help (why bear the costs yourself, if you can instead have someone else pick it up?). Rogoff sums it all up as:
“The balance of technology, complexity, and regulation is without doubt one of the greatest challenges that the world must face in twenty-first century. We can ill afford to keep getting it wrong.”
While this is definitely a “great challenge”, it is certainly not beyond our capabilities to devise a more balanced system that estimates overall risk associated with new innovations and sets price and liability levels such that businesses put more focus on risk mitigation strategies as part of their overall business strategy. While that may well feel like “regulation overshoot” to businesses keen to drive new innovations, it starts to puts prudence back into the equation and helps makes “conservative business practices” more of a virtue.
We could use a lot more of that, and not just in our global banking system.