In October 2008, our financial system was perilously close to free-fall. We were worried about a hard landing but could not even guess where or when.
A year later, Alan Greenspan testified before the Committee on Oversight and Government Reform for the U.S. House of Representatives. As the former chairman of the Federal Reserve he had presided over the design and manufacture of the financial bubble that had just burst, and lawmakers wanted an explanation.
There have been a lot of words spilled in the wake of the financial system meltdown and subsequent Great Recession. Still, Greenspan’s testimony stands as the most thoughtful and potentially useful, not only as we tinker with the economics and the politics of financial reform but also as we consider how to deal with the hazards of undersea oil wells.
Without doubt, some of his testimony was legacy-lofting; he is human, after all. At the heart of his responses to the committee members’ questions, though, was the admission that he had been wrong, not about some little thing, but about a fundamental tenet of economics: Individuals and institutions would act in their self-interest. This is our basic survival instinct as played out in our economy rather than in the battlegrounds of nature.
He had expected banks and financial institutions to avoid excessive risk because no bank would want to fail, just as few of us would want to die, those forced to read economics texts being the principal exception.
Self-interest is at the heart of economics and it is also at the heart of leading, guiding and regulating human behavior in civilized society. Our understanding of self-interest, though, is profoundly imperfect, even on a good day.
Self-interest and its curious relationships with systemic risk and “externalities” are what make the Wall Street implosion and the Deepwater Horizon oil well explosion so much alike. It is also what is making the regulatory cleanup so difficult in both cases.
Externalities are the costs and benefits of an economic activity that are not embedded in the price. When an oil company sells gasoline, for example, the at-the-pump cost includes the costs of production and distribution as well as profits for the owners. What it does not include are any costs associated with using it — air pollution, for example, in this case. That is an external cost borne by someone else.
Not all externalities are costs. Sometimes external benefits are not included in the price. My health risk, for example, goes down if my neighbor pays to be vaccinated against diseases. That is a positive benefit to me although I didn’t pay for it. A similar external benefit would accrue to me if he bought a new belt sander, which I could then borrow, but that is more the stuff of TV sitcoms than economic theory.
Self-interest, or, more accurately perceived self-interest, is a key element in understanding the BP oil spill. Congress and the Obama administration have been working hard not only to make BP just responsible for the catastrophic oil spill in the Gulf of Mexico but also to portray the company as a villainous corporate predator willing to despoil the planet to feed its selfish, insatiable appetite for profits.
So far, it isn’t getting much traction, except with those who were already committed to the idea long before this spill. Even the president cannot seem to shift the public’s focus from the cleanup to cleaning BP’s clock. There is growing public anger about the company, but no one really believes that BP wanted its oil rig to blow up, kill its workers, and create the largest and most destructive oil spill in history. It doesn’t make sense.
The key is how we deal with self-destructive behavior. Alan Greenspan noted in his testimony that he and his colleagues had trouble understanding the “self-destructive” behavior of banks as they poured money into increasingly risky mortgage loans.
All they needed to do was open the window and take a look around. Self-destructive behavior is everywhere around us except in economics theory. The landscape is dotted with rehab centers and dry-out camps for DUI-prone alcohol and drug abusers. Clean and sober banks make too many stupid loans. And kids drop out of school and join gangs.
Corporations engaged in self-destructive behavior underestimate risk or block out thoughts of it entirely, just as individuals do. A major goal of regulation, especially in areas where externalities are so potentially devastating, is to reveal the risk for what it is and take steps to deal with it.
If BP’s Deepwater Horizon oil spill teaches us anything it is that we cannot outsource our understanding of risk. Corporations simply have too many human failings for that.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
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