Financial Disasters and Natural Disasters: Which Are Worse?
May 17, 2010

“Since financial disasters are entirely man-made, in principle they should be easier for Governments to deal with than natural disasters, which cannot be controlled. Do you agree?”

 

I don’t. Financial disasters are less predictable than natural disasters; those who expose the financial system to major risks can often shift their own risks to others; the depth and breadth of a financial disaster can be expanded by contagion; and it may be impossible to protect innocents from becoming victims of a financial disaster without helping the malefactors who caused the problem.  

Predictability

The ability to minimize the damage stemming from a disaster depends in good part on our ability to predict its occurrence early enough to react in ways that reduce the damage. While the predictability of many natural disasters (such as the recent earthquake in Haiti) is low, in some cases it is fairly high and rising as the science improves. For example, in the Mt. St. Helens eruption in May 1980, seismic activity forewarning an eruption occurred some two months earlier, and Government-imposed restrictions on access to the danger area based on these early indications limited the loss of life.

Meaningful predictability of financial disasters, on the other hand, is nil. While there are always astute individuals who foresee that trouble is brewing, their knowledge is not translated into Government actions to mitigate the damage. A major reason is that counter-opinions may be as widespread and as influential. The counter opinions, furthermore, are supported by many who are profiting from the activities that are leading to disaster, and who are likely to belong to organized trade groups.

Underlying financial disasters, in other words, are malefactors who  profit from the activities that lead to disaster, obstruct any efforts to restrict these activities, and attempt to shift the cost of the disaster to others. There is no counterpart in natural disasters. 

Perceptual Bias

Human beings in general have a tendency to disregard or undervalue low-probability events that would have severe adverse consequences. This bias probably is protective on balance, because if we focused on every low probability hazard that might befall us during the day, we would never get out of bed. Nonetheless, the bias plays an important role in both natural and financial disasters.

Consider home buyers deciding whether or not to move onto an attractive flood plain that over a long period has averaged a devastating flood every 50 years. The probability that a flood will occur in any one year is thus about 2%. Based on experience over many such situations, we know that after some years pass without a flood, people will begin to move in. The longer the period without a flood, the more people behave as if the likelihood of one has gone down, though there is no rational basis for this belief. This behavior is reinforced by positive contagion – the fact that some have done it successfully encourages others to follow..  

The perceptual bias in the buildup to a financial disaster is even more powerful. Consider mortgage lenders who can make a lot of money writing loans for subprime borrowers so long as home prices continue to rise at a rate that is twice the long-term average. The longer the high rate of appreciation continues, the more lenders jump in the game, as if the longer period increases the likelihood that the price bubble will go on indefinitely. Yet the reality is that the longer the above-normal rate of price appreciation continues, the closer is the date when the bubble must burst. Positive contagion plays a role here, too – WAMU is making a lot of money in this market, why not us?

The perceptual bias of lenders confronting the sub-prime market is stronger than that of home purchasers confronting a flood plain in the following sense. If it were known with certainty that there would be a devastating flood in, say, 5 years, few home buyers would buy in. However, if it were known with certainty that the house price bubble would not pop for 5 years, lenders would not be deterred at all. They would assume that they could make much more money in the 5 years than they would lose in the sixth, especially if they can shift most of the loss onto others. 

Risk-Shifting

Ignoring the potential losses from a future disaster is rational to the degree that such losses can be shifted onto others. Some risk-shifting goes on in the case of natural disasters in the form of subsidized insurance to those exposed to natural hazards, or free assistance rendered after the disaster hits. But such risk-shifting is small potatoes compared to what can happen in the build-up to a financial disaster.

The lenders originating sub-prime mortgages sold them as fast as they could to investment bankers who securitized them as fast as they could. The risk finally lodged with investors who purchased securities they didn’t understand, relying on credit ratings provided by agencies who were paid for ratings by the investment bankers.  

Negative Contagion

As noted above, positive contagion arises in the buildup to both natural and financial disasters, but negative contagion arises only in connection with financial disasters. The scope of natural disasters – how extensive, widespread and long-lasting they are -- is determined by nature, but the scope of financial disasters is expansible through negative contagion. Fear is perhaps the most contagious of human emotions.

A financial disaster involves a loss of confidence in the ability of one or more major players to meet their   obligations. In the bank crises that occurred during the 19th century and through the great depression of the 1930s, the loss of confidence was largely limited to commercial banks and their ability to repay depositors. Contagion resulted in bank runs, which could jump from one bank to another, often with little discrimination.

In contrast, runs during the recent crisis involved withdrawals from money market mutual funds holding commercial paper, and refusals by investors to roll over maturing repurchase agreements and commercial paper. All three types of runs were stopped by early and resolute actions by the Federal Reserve. Otherwise, the crisis would have spiraled out of control.  

Assisting the Victims

The victims of natural disasters are clearly identifiable, and the only issue that arises in connection with helping them is their possible culpability for being in harm’s way. The potential victims of financial disasters may be very difficult to identify early enough to help, and helping them usually requires helping the malefactors who owe them money. These “bailouts” are a major source of political turmoil.

In sum, financial disasters pose more difficult and complex policy issues than natural disasters. That doesn’t mean, of course, that financial disasters constitute a greater threat to mankind. While a financial disaster mishandled could cause a world-wide and long-lived depression, a natural disaster could destroy the world.  

 
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