Normal accidents

Perrow (1984, “Normal Accidents: Living with High-Risk Technologies”) noted that tightly coupled systems are more prone to accidents.

Population ecologists (Hannan, M. T. and J. Freeman, 1977, “The Population Ecology of Organizations” ) tell us that specialization is a response to the demands for efficiency. Specialization leads to increasing interconnectedness and interdependency; in other words tight coupling.

The near collapse of the world financial system this fall, a crisis brought about by a very small perturbation (only 2% of mortgages are in foreclosure), seems to be a good example of a normal accident.

As firms increasingly outsource and reduce buffers between system elements in the quest for efficiency, are we going to see similar accidents in other sectors I wonder?

A question answered

A few weeks ago, I posed a question: how will the bailout plan simultaneously unfreeze the credit market and ensure that taxpayers are not left with the bill. I think I now have an answer. Nationalizing the banks (taking share in exchange for cash) fixes the weak balance sheets in a way that buying troubled assets at fair market value did not. And it appears that the terms are not that shabby; a guaranteed 5% return with greater upside potential if the banks' shares do well.

In other words, the plan, in its original form was never likely to work without the taxpayer taking a bath. This new approach looks a lot better.

A passing thought

Sometime early next year I imagine, AIG will hold its annual shareholder meeting. Someone will walk into that meeting holding a certificate for 80% of AIG’s shares. Will the name on the share certificate read “Secretary of the Treasury Henry Paulson”? If so, how will he cast his vote? Just a passing thought…

The Market for Lemons

Akerlof (1970) pointed out that when there is asymmetric information with the seller knowing more about the true quality of the product than the buyer, the only items up for sale will be lemons. The Treasury is likely to be in just this position when it offers to buy toxic assets from over-extended banks. Talk of ‘eventually making a profit’ from the purchase of such lemon-flavored assets thus seems, at best, overly optimistic.

Identification

Identification: a feeling of belonging to something larger than oneself.

When one group is treated differently from other groups, people might be forgiven for adjusting their frame of reference. The larger group to which they once thought they belonged - and owed some allegiance - may be replaced by a smaller more proximate group. The Wall Street bail-out risks creating such a shift. Small business owners may wonder why it is acceptable for them to fail but not for large Wall Street firms. Home owners struggling to pay mortgages, other who have lost their homes.

Arguments about vital interests and the like, while intellectually comprehensible, are hard to swallow in a culture that holds dear the notion that everyone has an equal shot - but by the same token faces the same risks. If care is not taken in how the Emergency Economic Stabilization Act is implemented, fissures may appear in the rather delicate fabric of our society (sorry Lady Thatcher - there is such a thing as society).

Moral Hazard

Allowing those investment banks that found themselves unable to meet their obligations to creditors not to fail creates a moral hazard problem that will haunt not only the financial services industry but all businesses in the US for a generation.

• We have signalled to outside directors that they need not exercise due diligence in oversight of the companies on whose boards they sit.


• We have signalled to managers agents that their risky behaviour has no downside and thus that there is not cost to risky behaviour in the future.


• And we have signalled to owners - shareholders - that they need pay no heed to the actions of those working on their behalf. Their investment is guaranteed.

Everyone - owners and managers alike - how has an incentive to take ever larger risks. If they win fine; if they loose, not a problem, someone will come to their aid. The problem is that those who are being asked to provide that aid is all of us, the US taxpayer. We have created an expectation, not just in the banking sector, but thought the business community that if you are large enough, no harm will be allowed to come to you, if you’re big enough. Small business owners may create half the wealth in this country but they are not equal recipients when it comes to a transfer of wealth from Main Street to Wall Street and beyond.