Understating the Benefits of Avoiding Low-Probability Disastrous Consequences

The big flaw in the business critique of regulation is not so much that it overstates the costs, but that it understates its benefits — in particular, the benefits of avoiding low-probability events with disastrous consequences.

Think of oil spills, mine explosions, financial meltdowns or even global warming. There is a natural tendency of human beings to underestimate the odds of such seemingly unlikely events — of forgetting that the 100-year flood is as likely to happen in Year 5 as it is in Year 95. And if there are insufficient data to calculate the probability of a very bad outcome, as is often the case, that doesn’t mean we should assume the probability is zero.

-Steven Pearlstein

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Fascinating quote that explains the game theory — and mathematical foibles — of the deregulatory free market extremists. This perfectly sums up the rationalizations used by those people who have emphasized the costs of regulation, but not the upside.

In a Democracy, when taxpayers have attempted to collectively protect themselves against corporate (and other) monied interests have had to argue against a growth storyline. That of course, turns out to have been a false narrative, but it carried the day for decades.

Pearlstein adds:

The biggest oil spill ever. The biggest financial crisis since the Great Depression. The deadliest mine disaster in 25 years. One recall after another of toys from China, of vehicles from Toyota, of hamburgers from roach-infested processing plants. The whole Vioxx fiasco. And let’s not forget the biggest climate threat since the Ice Age.

Even if you’re not into conspiracy theories, it’s hard to ignore the common thread running through these recent crises . . . regulators who were blinded by their ideological bias against government interference and their faith that industries could police themselves.”

What we have done, in essence, by following the ideologies of the Chicago School and others absolute Free Market believers, is to adopt the Victor Niederhoffer approach to trading risk. Niederhoffer writes puts on low probability events. This trades off short term gains over a period of time, in exchange for a longer term risk. He understands and accepts this. For a few years, he does very well — until he blows up spectacularly. Indeed, the way Nassim Taleb came to prominence was being on the other side of Niederhoffer’s trades, betting on the eventual reveal of a Black Swan.

The deregulatory approach is quite similar: We get faster growth, more profits, but occasional spectacular blowups.

Perhaps the best way to think about what (I have derisively termed) free market extremism and radical deregulation is to recognize what they are preaching: Its a high-risk, put writing strategy. Over the near term (A decade or 3), it guns growth and seems to be working. Mathematically, it is guaranteed to end in disaster . . .

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Source:
Time for industry to end its war on regulation
Steven Pearlstein
Washington Post, May 26, 2010; A13
http://www.washingtonpost.com/wp-dyn/content/article/2010/05/25/AR2010052505154_pf.html