Recent discussions of the malfunction of Wall Street have centered on the role of statistical models that failed to accurately account for all possible outcomes. These less likely results, known as "tail risks," were underestimated by the models. Now the "quants" on Wall Street and academia have a new research agenda, which is to figure out how to fix those models.
Telling the story in this way has a risk of its own. Focusing on inanimate abstractions and numbers diverts attention from the human conflicts and follies embodied in our current catastrophe. The challenges related to the distribution and management of risk are much more formidable than a technical fix because they are not technical problems. Managing and balancing risk in the future is an organic human problem, a political problem, and a problem of power. The question is how to remedy the fact that some players have the power to shift risks and to use the political process for insurance, while others do not.
Risk is inherent in the world. Natural disasters, wars, famines, floods, as well as the business cycle and disruptive innovations all introduce risk into life. A properly functioning capital market, working together with government, serves to diversify and distribute that risk to those who can bear it. Social institutions are set up for collective support for the aged and weak and those who fall prey to natural disaster. We've forgotten that in recent years, when society was caught up in the urge to be "entrepreneurial" and to show a hearty appetite for risk. Declaring oneself a "risk taker" was a badge of honor.
We undermined the public institutions constructed to bear risk and insulate citizens from the worst consequences. Healthcare policy treated patients as empowered consumers, ignoring their fundamental vulnerability. (Most people heading to the emergency room are not focused on comparison shopping among providers.) Congress cut back on bankruptcy protections for individuals. At the same time, unemployment insurance, welfare, and other aspects of the social contract were charged with creating a disincentive to work. When it came to institutions that protect individuals, concerns about moral hazard were rampant in the economics departments throughout the land. To be sheltered from risk was to be weak or corrupt.
Unfortunately, all this concern about perverse incentives of the weak and unfortunate was not applied in the world of finance. Free-market fundamentalism dominated academic and political debates. Regulations and restraints on the behavior of financial institutions and investors were seen as inefficiencies and unnecessary constraints, getting in the way of greater and greater financial efficiency.
In these elaborate intellectual portrayals of the financial marketplace, little attention was paid to the well-known fact that if a financial crisis were to emerge, officials would step in to truncate the risk of the downside in the name of containing "systemic" consequences. Systemic consequences mean spillovers from the financial sector to the real economy. In this case, just as drivers in an era of cheap gasoline don't worry about the costs of climate change, private participants in the financial system were not pricing the societal consequences of the risks they were taking.
It is important to note that the problems of financial excess introduced risks into society that need not be present. Factors such as excessive leverage, balance sheet complexity, and executive incentives that encouraged risky behavior fostered a system that did great and unnecessary harm. The financial sector did not merely transfer risk onto the taxpayers. It greatly amplified the risk, and took out large bonuses, before handing the bill to the victims across the national and world economic landscape. It is tragic that at the same time we subjected many to the sharp edge of unavoidable risks by weakening social protections, we fanned the flames of risk amplification by the powerful, using the promise of public money to give them a sense of invulnerability. …