Russ Roberts

Greg Ip on Foolproof

EconTalk Episode with Greg Ip
Hosted by Russ Roberts
All the World's a Puzzle... Knowledge, Ignorance, and Spec...

Foolproof.jpg 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.

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Podcast Episode Highlights
0:33Russ: Before introducing today's guest, I just want to remind listeners to please go to 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!
0:56Russ: 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.
6:47Russ: 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.
13:24Russ: 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.
19:15Russ: 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.
23:37Russ: 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.
30:20Russ: 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.
36:53Guest: 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.
42:20Russ: 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? They have the concussion protocol, which is--I think it's a step; I don't know if it will be sufficient. No one knows. We'll find out. Guest: So I think one of the things that goes into this equation is: What does the public or society expect? What is their appetite for risk? So the way you're pointing to is that in many families, in many communities, they do not believe that the risks involved in things like football are worth the athletic experience or the spectacle that they've enjoyed. People's attitudes are changing. And this is something that's happening over time, as though we as a society have become much more attached to safety. And indeed you could say it is one of the progressions of affluence--that as we become wealthier, more safety is one of the things we purchase. And this is actually one of the points that Sam Peltzman made very astutely in his work on automobile safety. He was able to show that automobile accidents and fatalities had been on a long declining trend even before the Federal government stepped in, in the 1960s, and began creating and enforcing all these new regulations. In fact, if you look at an 80-100 year trend of automobile fatalities, it's very hard--it's not exactly straight but it's definitely hard to see the effect of increased regulation. And what does this tell us? Well, a lot of people don't realize is that seatbelts were originally an option. Auto makers introduced them because they thought there might be people out there who would like having safety belts. The same with anti-lock brakes. A lot of the things that we now associate with the nanny state imposing on us were in fact, options that were added because the automakers surmised that some people might actually want this. And indeed, people will now routinely pay thousands of dollars for optional upgrades to their cars for things like electronic stability control and anti-collision stuff. And this is--one of the things that we have to realize is that when you are trying to figure out why things have gotten safer, is it because somebody stepped in and made it safer, or is it because people's risk appetites changed? And, again, this is where research can answer the question, because you can study this quite closely. But I think in the case of automobiles, while I do believe safety belts and safety belt laws have helped, they've signaled[?] a most important trend going on, that over time we as drivers, we as families and parents, put a much higher priority on safety. And by the way, we have the affluence and the disposable income to purchase these things that we couldn't have before. There are times when this arguably goes a bit too far. The whole issue over free-range parenting, which I'm sure you've heard about: this is the idea that it's somehow considered radical to actually let your pre-teen children walk to school by themselves. We as parents have probably in some cases gone a bit too far in being overprotective of our children. I'm not making the case that this is leading to more injuries for our children, but it is arguably depriving them of experiences as they grow up. So, this is all a matter of getting the balance right. But the only point I was trying to make is that whether or not we are safe as a society has a lot to do with what our fundamental tolerance is for harm. Russ: Yeah, I totally agree with you. And I think, as an example of that free-range parenting, being in the opposite, we've had Moises Velasquez-Manoff as a guest--I'm looking at the date here--back in 2014 in March, where he argues in his book, An Epidemic of Absence, that in our relentless desire to purge our personal ecosystems, our bodies, of parasites and other diseases, we've encouraged a set of autoimmune diseases to expand. That wasn't our intention, of course, but there's no free lunch, unfortunately. And we make our children safer by giving them a clean environment, and they are more likely to get sick when they get older. We make it safer by keeping them away from excitement, and there's a cost there, too. It's not as obvious but I think there's definitely a cost; and I say that as a parent who struggles with this issue. I love protecting my kids. My dad used to say: It's important to walk barefoot, because the grass feels good. We're not so good in our generation about letting our kids go barefoot.
52:06Russ: Let's turn--I want to make sure we talk about some of the ecological examples you give, because your discussion of hurricanes--we talked a little about forest fires, but the hurricane discussion and other natural disasters is extremely interesting. Talk about Hurricane Sandy and its impact on New York and how that was affected by past--both by our income, our growth, our increasing affluence but also by some things we had done in the past to make it more likely that people lived in its path. Guest: Yeah. Well, Hurricane Sandy was the second costliest storm in U.S. history after Katrina. And it certainly had a pretty profound impact both in the economy and on politics, frankly. Mike Bloomberg, who is the Mayor of New York City, said that the storm caused him to endorse the Democrat Barack Obama because he decided the storm elevated in his mind the importance of climate change. Now, I do believe that climate change is happening, that it has man-made origins. But the data and the evidence do not tell us that Sandy was a consequence of climate change. It is definitely the case that over time storms--we're getting more costly storms. But this is almost entirely a consequence of the fact that we are putting more and more valuable infrastructure on the Coast. New York City, as it turns out, is perfectly situated to be hit a couple of times a century by a very damaging storm. And the reason why sometimes people are shocked by it is that they don't come along very often. The last one before Hurricane Sandy had been in 1938--it was called the Great New England Hurricane. Actually, am I getting confused? Maybe it was the Long Island Express. Forgive me. Russ: Sounds like a football player. Sounds like a good running back. Guest: It does, doesn't it? But it was a very damaging event, and it actually carved new inlets on Long Island. But by the time Sandy had come along, people had forgotten about that. And a lot happened in New York in the meantime. A lot of these crummy little houses on the Jersey Shore and Long Island become these multimillion dollar mansions. You'd opened like airports and tunnels and so forth. In my book there's a fascinating chart that shows the value of structures in the 100-year flood zone of New York City, and you can see the number just shooting up over the last 70 or 80 years as we put more and more valuable infrastructure right on the edges of New York City. So, the catastrophe experts--people like consultants who do this for a living--they were not at all surprised that something like Sandy would come along and have the cost that it did. Because, they had said, 'Well, what do you expect when you put all this valuable infrastructure right in the path of where we know a hurricane one day is going to hit?' And we can expect more of this going forward, for two reasons. One is because, as the climate gets warmer, the sea levels will rise and we'll get more [?]. But, also because not just in the United States but around the world, more people are settling on the coast. We have cities like Guangzhou and Shanghai, and Mumbai, and Jakarta. These are the most rapidly growing agglomerations of people and industry in the world. And they are all sitting right on the water, sitting smack in the path of storms and floods. So we are going to have more Sandys in the future. Russ: One of my favorite things in your book--it's just a trivial thing but I just loved it: the picture of where the biggest damage was in Hurricane Sandy was property that literally did not exist 100 years ago--I think it would be a hundred years ago; I think that's right. Guest: Yeah. 1609. Russ: Wait, what was it? Guest: 1609. That's when the original Manhattan Island is shown in that map. Russ: So, in 1609, Manhattan was smaller because we've reclaimed land. We've added land. People like to say land is fixed. I think that's a very misleading idea. It seems fixed. But it's not fixed. For one thing you can build up. You can build higher buildings. But the other part is you can literally add land. You can take stuff that's water and turn it into a habitable territory. And we've done that in Manhattan, because it's profitable. And that's where the worst damage was. If we hadn't had the ability to do that, the damage from Sandy would have--would it have been smaller? Actually, now that I think about it, maybe it's just that it was close to the edge. Maybe that's a little bit misleading. What do you think about that? Guest: No, no; I think I'm happier saying [?] was exactly that. That if you look at the land that's being reclaimed, corresponds almost exactly to where Hurricane Sandy[?] was. This is not an uncommon thing. Low-lying areas and reclaimed areas are always like that: 60% of the Netherlands is below sea level. And these are why the Netherlands is very vulnerable to storms and flooding. And so, the way I like to say it, is over the last 4 centuries, New York took all this land from the sea and then in 2012 the sea asked for it back. But the other point I want to make is that this isn't necessarily a bad thing, because it's not like that land was wasted. New York did something very valuable with that land over those 400 years. They built up a very prosperous city. And this is an important thing to remember, the larger point, is that, sometimes taking the risk of a disaster like that also increases your productive capacity. So, New York had the ability to rebuild after Sandy because it was such a prosperous place. This is the irony, is that the very things that make cities like New York, like Miami, like Hong Kong vulnerable to storms are also the same things that make them prosperous. Proximity to water has long been associated with being a commercial center. People like living next to the water. Nowadays, where intellectual rather than physical capital is the driver of economic growth, smart, talented people want to live next to each other. And that's what you have in places like New York, London, and Hong Kong. And what this means is that even though they will periodically be damaged by a storm, they have the GDP, they have the capital, they have the means to actually rebuild afterwards. So, it's not necessarily shocking, or even bad, that these places will periodically sustain this damage. What we as a society want is to make them as resilient to the damage as possible, not to say, 'The water must be kept out at all means' or even more radically just move the city somewhere else. But in the design and maintenance of those cities, make the, anticipate that these events will come along and make sure that you can recover as quickly as possible afterwards. Russ: Yeah, I just want to say--because it's fun--I want to mention that across, right in front of the Hoover Institution is a fountain, at Stanford University; and there's a quote from Herman Melville on that fountain's edge. And I'm going to read the passage from Moby Dick; and the end of this passage is the quote that's on that fountain. So, this is Herman Melville. He says
Say you are in the country; in some high land of lakes. Take almost any path you please, and ten to one it carries you down in a dale, and leaves you there by a pool in the stream. There is magic in it. Let the most absent-minded of men be plunged in his deepest reveries--stand that man on his legs, set his feet a-going, and he will infallibly lead you to water, if water there be in all that region. Should you ever be athirst in the great American desert, try this experiment, if your caravan happen to be supplied with a metaphysical professor. Yes, as every one knows, meditation and water are wedded for ever.
And that last phrase, "meditation and water are wedded for ever" is what is inscribed at that fountain. It's one of the most beautiful lines, because the worded 'wedded'--w-e-d-d-e-d--also sounds like 'wetted,'--w-e-t-t-e-d. So it's a work of genius. He says later on by the way, "Were Niagara but a cataract of sand, would you travel your thousand miles to see it?" So, we do like, as human beings for whatever reason, we do find water attractive. It's why there is huge population intensities at the water's edge. And it's why there is going to be destruction of human, tragically of life and property, when inevitably that water doesn't stay where we hope it stays.
1:00:24Guest: Yeah. Can I mention something? Because you brought up the Hoover Institution? Russ: Yeah; sure. Guest: Well, in my book I actually talk about Herbert Hoover, who I think is an interesting figure in American history. Because, in my book I sort of describe many of the tensions between our desire to make everything more complicated and safer, and the opposing desire to actually let nature have its way, as a tension between engineers and ecologists. Russ: Love that. Guest: And Herbert Hoover is still, is the only President who was once an engineer. And the engineering philosophy ran through many of the policies that he pursued and advocated as a President. I can't remember who-- Russ: And before, when he was an expert fighting famine, trying to help people--he saw it as a logistical problem. Guest: Yeah. There's a lot to admire about Hoover. I can't remember who it was who called him the most innocent bystander in history. Because a lot of people have the myth that he basically stood by and allowed the Great Depression to happen.-- Russ: Correct: not true. Guest: He actually tried to do a lot to stop it. Russ: Much of which Roosevelt (Franklin D. Roosevelt) did more, did just more of. And it didn't work so well, either, but he got credit for it. It's fascinating. Guest: My father was an engineer; my brother is an engineer. I have a lot of sort of connection to engineers. And when I was visiting the Hoover Institution a years ago, I went into the Hoover Institution Memorial there, and I saw a quote from him that he wrote in the 1950s. He said it was the engineer's duty to 'clothe the bare bones of science with life, comfort, and hope.' And I found that just such a very profound statement. And again it fully captures this instinct I'm talking about throughout my book--not just on the part of our technological engineers, but our economic engineers and our environmental engineers. That is what they are trying to do: they are trying to clothe the bare bones of a wild society with life, comfort, and hope. And so it's difficult for me, philosophically, to say they shouldn't do that. Because isn't that what civilization is for? We just need to remind from time to time that they can't do everything, and we shouldn't ask too much of them. Russ: Yeah. I'm more of an ecologist. And I often make that contrast between ecology or biology, and leaving things alone, on the one hand; and solving it, engineering it, fixing it on the other. And I think it's--you have to know where it works and where it doesn't. You point out in the book that airplanes have gotten safer and safer. And that's mainly the triumph of the engineers. Different kind of complexity, I would argue, than, say, the financial system. Guest: Yeah, or even automobiles, for example. Will driverless cars make us safer? I think so. But on the other hand, there's been some evidence that the driverless cars are so sensitive to stop signs that they stop too fast and people keep hitting them. So, the truth of the matter is we don't really know where these things will go. These are fascinating questions. And obviously this is where science and economics, the scientists and the economists, can all make a contribution by studying our behavior. To give you one example--we talked about football helmets. Let's talk about motorcycle and bicycle helmets. Some people don't like to be forced to wear motorcycle helmets. But the research does show that motorcycle helmets do save lives and they don't seem to cause offsetting behavior. But the research also shows that bicycle helmets don't seem to save lives. And yet, if you are wearing a helmet--sorry, you were going to say? Russ: Well, there are actually studies--I don't know if they are any good, but there are studies that argue that people who wear helmets are more likely to be hit by a car, either because they're being more reckless or the drivers of the cars think--subconsciously--it's hard to believe, but that's the ultimate Peltzman effect: You seen a guy with a helmet on and you think, 'Ehhh, he's fine; it's okay[?] if I knock him over.' It's a horrible-- Guest: Yeah; I've seen that research. Russ: It's a horrible, horrible thought. I don't know if it's really true. But there's some evidence that it is. Guest: Yeah. I mean, those are very small studies. But what the larger studies do seem to show is that--look, you know, I think wearing a helmet on a bicycle is a great idea. I always wear a helmet, and my kids always wear helmets. The question arises: Should the government force you to wear a helmet? Because it turns out when you do, fewer people ride bikes. If fewer people ride bikes, they don't get the cardiovascular benefits of riding bicycles. The community doesn't get the environmental benefit of people riding bicycles. And here's the kicker: With fewer bicycles on the road, drivers are less aware of them; and they appear to drive faster. So the absence of cyclists actually makes it a little more risky for those who are there. And that's why I think that the case for bicycle helmet laws is much weaker than the case for motorcycle helmet laws. Russ: Yeah; and you give the example of airplane safety, where, as you make planes safer, you do drive up the cost; and that encourages more people to drive. And driving is much more dangerous. So there's an incredible tradeoff there that isn't obvious to an engineer. Guest: Yeah. Although one of the interesting lessons I drew from aviation is I talked a lot about how the sense of safety can actually bring on danger. A sense of danger can bring on safety: and I actually think aviation is the classic example of that. Because so many people are afraid to fly; and airplane accidents get so much publicity, that I think it drives the industry, and the regulators, to go overboard almost with their safety requirements. And that's one of the reasons why it's so incredibly safe to fly. Russ: Yeah. And I encourage listeners to become readers and check out your discussion of airline safety there generally in your book. Because it's really--I learned a lot in there that I didn't know.

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COMMENTS (19 to date)
David McGrogan writes:

Great podcast, but it will go down in history for me as the moment when Russ declared rugby to be "less entertaining" than American Football. I wonder how many eyebrows were collectively raised by Russ's listenership in the British Isles, France, South Africa, New Zealand, Australia, etc. at that!

Although it does make me wonder if there's space for an Econtalk episode on the popularities of different sports in the US and elsewhere...

SaveyourSelf writes:

~13:00 Greg Ip said, “no system can insure itself.”

A brilliant restatement on the importance of diversification. Insurance is, I believe, a mechanism of diversification. Diversity—or diversification—is one of the simplest, least costly, and most effective means to decreases risk. Regulation—generally in the form of government intervention—abolishes diversity. Therefore, regulation—as a general principle—increases risk.

~19:00 Greg Ip said, “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.”
~24:00 Russ Roberts said, “Now it's true, and memories are short; but I think if it's really awful, the memories tend to last longer.”
The importance of forgetting has long been missed in the economic models discussed on Econtalk. I am thrilled to see it make such a substantive appearance.
As a side note, I suspect that forgetting—and it’s importance to the general human method of assessing risk—is the real source of Keynes’s, ‘Animal Spirits.’

Pyrmonter writes:

David McGrogan is right: the way to lose Australian and New Zealand listeners is to suggest gridiron - stopping and starting, produced for television - is somehow more entertaining than the game invented by Ellis-Webb and played in heaven.

More seriously - is there a link to the material summarised in the final 3 minutes or so regarding mandatory bicycle helmet laws?

[Thanks for your question about the link. Link, also added now to the link section above. -- Econlib Ed.]

Scott Trowbridge writes:

The Detroit Free Press reporting on remarks by Mark Rosekind, administrator of the National Highway Traffic Safety Administration, on 1/12/16 at the North American International Auto Show in Detroit:

"Someday, I believe, we will look back at the time when we allowed the sale of vehicles with safety defects and wonder, 'what were we thinking?'" Rosekind said. "For more than a century, vehicle safety was all about assuming crashes were inevitable. And now increasingly technology can prevent those crashes from ever occurring in the first place."

I am not sure I want a world where people believe crashes are impossible.

jw writes:

Greg Ip is a very good economist and writer and I certainly agreed with the overall message of this podcast and the book – the economy (and for that matter, life) is far too complicated to regulate fully and unintended consequences are usually more harmful than the perceived problems that were originally regulated. (With regard to an earlier post by another commenter, “unintended” is not the same as “unknown”, plenty of people were able to forecast the financial crisis and many of the other issues brought up in this podcast, but were ignored. True black swan events are very rare and the financial crisis was not one of them.)

Now to the quibbles:

- You have to be very careful to remember that not “everyone did it”. After carefully looking into the finances of available banking options where I live, I purposefully chose BB&T as a sound banking firm (PNC would have been another good choice.) Neither was caught up in the financial crisis. Unfortunately, most people choose the branch that is closest to their homes or run a nice ad. Per Russ’ earlier observations, it may not have been an economically justifiable use of time at the time for most people, but that turned out to be wrong. You can bet that everyone very carefully chose their banks in the 30’s.

And, if you believe John Allison, the former CEO of BB&T, Paulson and Bernanke essentially strong-armed BB&T into taking a government bailout so as not to divulge how close GS and others were to insolvency.

- Also, you must remember that the rating agencies were a government mandated oligopoly with perverse incentives since the agencies wanting to sell the bonds paid for the ratings. Incentives matter and the ratings agencies came down on the side of bonuses instead of objectivity.

- Per the Bagehot discussion in the Selgin podcast, central banks are not supposed to prevent recessions. They are supposed to the lenders of last resort in a liquidity crisis. And they cannot, and should not, try and reduce unemployment.

- There was a great deal of fraud in loan origination and derivative construction in the crisis, and a great deal of creativity went into inventing tools that appeared to reduce risk so that higher leverages could be employed and therefore bigger bonuses could be paid. I think that many are too forgiving of these machinations, believing that the stated intentions outweighed the obvious mathematical flaws and the resulting enrichment for their creators.

- SIPC and FDIC insurance are merely horribly underfunded marketing tools to give the illusion of insurance to small accounts. In a true crisis, they have an implicit government bailout, but that can change with the stroke of a pen or a quick Congressional vote (see Cyprus).

- Lastly, is the Fallacy of Composition a corollary to the Tragedy of the Commons?


In a global economy where major disruptions are quickly felt worldwide, I am not sure that you can fully diversify yourself either. Diversity only works when you have long term positive expectations for each component of your portfolio (even if they may be hedges - negative expectations that are negatively correlated to your portfolio). In the current environment of record worldwide debt levels, long term may be a very long time.

Andy Wagner writes:

One useful lens for looking at many of these topics is the Cynefin Framework

What forests and the financial sector have in common is that they both represent complex adaptive systems. Cause and effect linkages are unclear and dynamic, so its impossible to predict outcomes. Safe-to-fail experiments are the best recipe.
Commercial air travel, in contrast, is a complicated system. The causes of various risks can be cataloged, calculated, and countermeasures applied. Its the realm of proper engineers more the ecologists.

jw writes:


What if a system exhibits both complex and chaotic features, either simultaneously or via a rapid transition between states?

Drew writes:

In the discussion of anti-lock breaks Russ and Greg agreed that the safety measure may result in drivers driving faster, resulting in a much smaller safety benefit than one might expect. A nice analogy for the risks of trying to regulate safety in the financial sector.

But when drawing the parallel between driving to banking, both Russ and Greg seemed to skip over the point that driving fast is actually what people want. In the driving example, we have a regulation that slightly increases the cost of a car, but also increases both safety AND speed in the long-term.

I would be interested to hear Russ or Greg comment on how this second benefit of regulation in the driving example is relevant to the financial sector. A simple interpretation might be that the financial industry as a whole is trading some of the "safety" generated by regulation in exchange for a greater overall rate of return (because, like driving fast, it's what we really want). Could this be true, even in the long-term?

Eugene Kernes writes:

I originally thought that this talk would discuss the concept of antifragile based on the examples introduced with. The discussion made me realize that transferring risk by a 3rd party agent, the government, makes the system more fragile. In connection to the peltzman effect, as applied in terms of antifragility, a trade must be made between individuals safety and the systems safety. If we consider the offsetting events due to safety measures, it might be because of diminishing marginal returns as a little bit safer may not cause the system to be less safe.

jw writes:


Interesting question. IMHO, the car delivers the feature that drivers want, speed. The financial system does not deliver returns. The economy and the companies that participate in it deliver the returns, the financial sector is merely a fairly expensive conduit. Maybe there is a strained analogy to a road here, I don't know.

Keep in mind that the financial sector, even after Glass-Steagall was repealed, was subject to tens of thousands of pages of regulations. The incentives were on the side of inventing new instruments that circumvented these regulations, as regulations can never keep up with innovation. The market should have reined in these excesses, but again, the incentives were with the bailouts and moral hazard continues to increase (I refuse to believe that central bankers do not understand the net present value of $250K speech fees a few years in the future).

Debt continues to grow unabated and there are over a quadrillion dollars of derivatives out there that we have been assured by these same financial gurus have zero net risk to the system - and that this time is different...

Phil Brown writes:

I was very curious about the implication that auto safety has not improved over the last 50 years with the introduction of seatbelts/airbags and ABS.

Isn't this completely contrary to the recorded fatality rates? Looking on wikipedia it would seem that not only have fatalities per billion miles driven consistently fallen, but even deaths per 100K population have fallen since the 1970s. How do Greg and Russ assert that auto safety is flat?

The recorded fatalities would imply that the continual improvement in safety features has had a direct effect on auto safety, and would also imply that the argument Greg and Russ made that adding safety equipment causes risky behavior to be specious and not borne out by the data.

PS: have either of them actually ever watched a game of rugby? I would agree with other comments here on that topic, their argument was completely false. The relative popularity of other sports elsewhere in the world would imply that American Football is not very entertaining. My guess would be that there are cultural biases that are much more important than the spectacle of players smashing into each other.

Robert Swan writes:

Funny about the football. By and large I suspect the codes you like are more to do with cultural norms than any objective measure. If Americans like NFL because of the hard knocks, perhaps the same goes for NHL, but then why is NBL so popular?

Off religion, to safer ground.

Russ, you said you often make a distinction between ecology and engineering. I hadn't noticed, and it's a distinction I don't make. I gather you're equating engineering with central planning and ecology with emergent order.

Firstly, engineering is part of ecology. Humans have a drive to build things as, on a lesser scale, do ants, bees, birds and beavers. It's part of our nature. At a less trite level, engineering includes planning, but those plans evolve, within projects and between them. There's plenty of emergence in engineering.

Pushing the point, aren't central planners themselves emergent? Music was around long before the first conductor or even composer appeared. Today, some music benefits from a conductor, and some still doesn't even have a composer. Which music is best?

IOW, is the division into centrally planned vs. emergent economies actually a false dichotomy? Isn't the current level of central control in truth just a result of that economy's ongoing evolution?

jw writes:


To your last question - no, it is not. There will always be tradeoffs between security and liberty and regulation and liberty, but they do not "evolve" in one direction. China is certainly more free than it was 20 years ago (although it still has far to go) and the US certainly enjoyed more liberty at the end of Reagan's term than before Reagan, or now for that mattter.

So one might say that we are currently in a period of de-evolution.

This morning, I was reminded of this quote which perfectly applies to this podcast:

“The fundamental attitude of true individualism is one of humility towards the processes by which mankind has achieved things which have not been designed or understood by any individual and are indeed greater than individual minds. The great question at this moment is whether man’s mind will be allowed to continue to grow as part of this process or whether human reason is to place itself in chains of its own making.

“What individualism teaches us is that society is greater than the individual only in so far as it is free. In so far as it is controlled or directed, it is limited to the powers of the individual minds which control or direct it.”

- Hayek

Robert Swan writes:


My mistake for using the word "evolution" as it gave you the impression I meant progress to some ideal.

What I was meaning to say is that Russ is wrong to think emergence and central control are in conflict; in truth the level of central control is itself an emergent attribute. That's what I was driving at with the music analogy. If the band is tending towards a symphony orchestra it'll need a composer and conductor. If it tends towards a free jazz group it'll want neither.

Now that I think of it, quite a while ago, I think in a Mike Munger interview, there was the story of the team of workers who hired a guy to be their "manager". IIRC, he was armed with a whip and was to aim it at any of his slacking employers.

Easy to agree with Hayek, though Robert Burns got it pretty well with his famous "best laid schemes" couplet.

SaveyourSelf writes:

Robert Swan wrote, “Russ is wrong to think emergence and central control are in conflict.”

In a small way Robert Swan in correct, but in the main his statement is mistaken. First, individual rationing [not talking about emergence yet] and centrally-controlled rationing are often in conflict, but not always. Sometimes people prefer to have someone else boss them around. Usually, though, people are better able to make decisions for themselves and they know it, which means usually individual rationing and central rationing are in conflict. Second, emergence [of solutions to problems] always comes from individuals but individuals are present in both types of rationing systems. Thus, central-controlled rationing does not preclude emergence. However, to whatever extent one individual is making decisions for other people, there is--almost certainly--a net loss in numeracy and variability of solutions to problems. Take a majority rule system, for example, where—optimistically—51% of people pretend they are a single person and make decisions for themselves and for the other 49% of society. Changing from that majority-rule-centralized system to one where 100% of people make decisions only for themselves is likely to increase the total number and variety of solutions in the system anywhere from x2 to xinfinity. Since so much of innovation is trial and error, the number of trials is strongly correlated with the velocity and breadth of innovation, so the number of people attempting to solve problems is causally correlated with the rate and breadth of innovation. Thus, it is generally true that central control is, for all intents and purposes, negatively correlated with emergence. This model's prediction is very strong when comparing the extremes of the two rationing systems--self vs central. This model does not predict, however, the rate of decline in the emergence of innovation when the two systems are mixed (part central command + part self-directed).

Robert Swan writes:


Thanks for your response; always nice to be correct, even if only in a small way. Perhaps I can convince you to grant me more.

If I understand your comment correctly, you're saying that a more centrally controlled regime will try far fewer combinations of the possible approaches to a problem than would a less centrally controlled regime. I fully agree, and it's a good part of the reason why less central control often finds better solutions.

Assuming that was your point, notice that emergence wasn't mentioned at all; it's all about more or less central control. Perhaps, by definition, central control and emergence are the one axis with just the scale inverted. If that is the definition then I'm utterly and obviously wrong and freely admit it.

In explanation, the way I have been looking at it, emergence is exactly analogous to evolution. Evolution's whip and reins of mutation and natural selection have neat parallels in individual experiment and market evaluation.

In this view, the central planner is more in the role of a deity, at its whim commanding experimenters and evaluators. This deity can certainly affect the outcomes, but its presence doesn't invalidate the mechanism any more than "But God??" invalidated Darwin, even in C19 Britain.

As an aside, just because a free market tries many approaches doesn't guarantee it'll get a better solution than one central planner. An awful lot depends on the efficiency of the evaluation, and a central planner can be a surrogate for an unresponsive marketplace. Back on my music analogy, a school band with 30 players of varying skills will have a better chance of making something their parents will listen to if one of the skillful ones becomes conductor than if they all blow and strum and thump with their best efforts and hope for something to emerge from the numerous "interesting" combinations explored.

jw writes:


Your analogy breaks down in that that the band has the option of joining the new conductor or leaving.

Also, the conductor uses one baton to lead, the government uses 175,000 pages of regulations. One might conclude that this would stifle emergence to the point that it actually would guarantee that markets would get to a better solution.

Robert Swan writes:


If an analogy doesn't break down somewhere it isn't an analogy -- it's the thing itself. But you actually do have that liberty: the players can leave the band, you can emigrate.

That's not really to the point anyway.

It is terrible that there are 175,000 pages on your statute books, but where did they come from? Haven't a large number been created in response to market behaviours? And haven't a large number been amended in response to the market's response to their new laws? IOW, many of these laws are emergent. Doesn't make them good, mind you.

In evolution, predators, prey and their respective competitors all evolve together. That's how I see the unregulated market. The other factor in evolution is the environment. That's where I'd say the regulator finds its niche. It can change in a small way and affect the equilibrium point, or it can rain down an asteroid and spoil everybody's day. The evolutionary mechanism remains.

Sorry, I am one for analogies.

Jay writes:

With regards to the part of the discussion of economists as engineers. There are a few famous economists trained as engineers:

  • Vernon Smith
  • Jean Tirole
  • Vilfredo Pareto (really a Polymath)

At least the first two of these names have a free market bent. It seems like the discussion cast engineers as having a deterministic approach to problems. However, attempting to harnessing nature for human benefit can humble a person. It may lead one to realize that not all problems can be solved by engineering, as it may have the above economists

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