In a Washington Post article entitled “From the oil spill to the financial crisis,” U.S. Court of Appeals Judge and author Richard Posner described some of the reasons why we don’t adequately prepare for risks. Regarding the financial crisis, for example, he said,
“it is very hard for anyone to be rewarded for preventing a low-probability disaster. Had the Federal Reserve raised interest rates in the early 2000s rather than lowering them, it might have averted the financial collapse in 2008 and the ensuing global economic crisis. But we wouldn't have known that. All that people would have seen was a recession brought on by high interest rates. Officials bear the political costs of preventive measures but do not receive the rewards.”
Posner also noted that our tendency to procrastinate in addressing risks is aggravated “when the people responsible have a short time horizon”—that is, when short-term success matters more than the long-term outcome. Financial industry leaders who took outsized risks could do so in the belief that they would be financially secure by the time any crisis arose.
The conference committee deliberating over financial reform proposals would do well to bear this in mind when crafting the final version of the bill. Our leaders have the opportunity to take a longer-term view of our financial system and ensure that today’s political trade-offs do not become tomorrow’s elevated risks and crises. For example, auto dealers are exerting tremendous pressure on Congress to carve them out of the proposed consumer financial protection agency’s authority on the grounds that they didn’t cause the current crisis. But as financial industry participants handling the financing of most people’s second-biggest asset (after their home), the potential risk of financial disaster for consumers is huge if consumer protections do not apply to auto dealers. Elected officials who go against the auto dealer industry’s wishes may not be rewarded with campaign contributions. Consumers and military personnel who stand to gain a lot from the inclusion of auto dealers under the consumer agency’s authority must find ways to recognize and reward Congressional leaders who stand up for their interests. Our elected officials that properly look out for our long-term interests, despite the lure of hefty campaign contributions from special interests, deserve our thanks, votes, and contributions.
The flip side of this issue is that, under current practices, financial industry leaders who take excessive risks to gain short-term profits are rewarded with enormous salaries and bonuses. Rarely, if ever, have they been expected to pay them back or bear the liability for the long-term damage caused by their actions. In his new book, The Upside of Irrationality, behavioral economist Daniel Ariely shares some fascinating research on how ineffective and even counterproductive such enormous bonuses may be in influencing human behavior. Some of the proposed “say on pay” provisions in the financial reform bill could help to rein in some of the inordinate risk-taking that led to the current crisis.
While I lack expertise in the oil industry, I can see the obvious parallel that Judge Posner has drawn between the lack of regulatory enforcement in both the oil and financial industries. As we progress from the legislative stage of financial reform to rulemaking and implementation, it will be important to expand our time horizon, keep our human limitations in mind, and guard against financial products and practices that generate short-term profits but could again cripple our long-term economic security.