8/20/2019 Excerpt from "Foolproof" by Greg Ip.

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Stability and safety have long been a central preoccupation of  civilization; they are why

our lives have gotten longer, healthier, and more prosperous. Yet we still periodically

suffer devastating financial crises, costly natural disasters, and deadly accidents. When

we look closely at the behavior that precedes these calamities, we discover that they are

often the unintended consequence of our pursuit of safety. “Stability is destabilizing,” is

what Hyman Minsky concluded about the tendency of stability in the financial system

and economy to breed complacency and, ultimately, instability. But it is true of much

more than that. Everything we do to make ourselves feel safer brings with it the inherent

danger of amplifying our appetite for risk taking, the possibility that we’ll treat

something dangerous as less dangerous, and the potential for panic when we discover we

are wrong.

 

The world’s twin financial crises were the product of this pursuit of safety. By defeating

inflation, the Federal Reserve ushered in the Great Moderation, an era of subdued

business cycles that made it safer to buy homes and take on debt with the help of 

 

financial innovations that made risk more manageable. Europe’s leaders sought to abolish

the currency crises and political tensions that threatened their unity by introducing a

single currency. Both the United States and Europe were so successful that they

unleashed massive booms in borrowing that ended in financial catastrophe.

 

The high cost of many of the natural disasters in recent years, so often blamed on climate

change, are in fact more the product of our efforts to put cities, people, civilization, and

wealth in nature’s path, where they can be destroyed.

 

The pursuit of safety is usually effective. Most of what we do to stay safe works becauseit doesn’t cause offsetting behavior. Washing our hands with ordinary soap does not

cause germs to develop resistance, and teaching your child to look both ways before

crossing the street does not increase the volume or speed of traffic. The challenge arises

when making an activity safer changes people’s behavior, offsetting some or all of the

benefit. Sometimes this is because making an activity seem safer leads us to do more of it

or do it more dangerously, the way antilock brakes and studded snow tires encourage us

to drive in conditions when we might have stayed home or driven more slowly. Financial

innovations such as mortgage-backed securities and derivatives allow an individual or a

bank or a company to do something risky, then transfer some of the risk to someone else.

The belief  that they are now safer encourages them to take more risk, and so the level ofaggregate risk in the system goes up.

 

Or it might cause the risky activity to migrate elsewhere. In the 1980s, fear of another

banking crisis led to rules on banks being tightened. But that didn’t change the demand

for credit or the desire by investors and borrowers to buy houses or take on riskier

investments. Consequently, lending and risk migrated to less regulated shadow banks.

8/20/2019 Excerpt from "Foolproof" by Greg Ip.

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Public concern curtailed construction of new nuclear power plants in the 1970s and 1980s

but not the need for electricity. So alternative generating sources had to be found, and

many, such as natural gas and coal, are more dangerous for our health.

 

As individuals we are not expected to evaluate how others’ behavior will change if

everyone does what we do. We’re hardwired to be selfish, to take the action that benefits

us as individuals; we seldom have the foresight or the incentive to put ourselves at risk

for the sake of making society safer. This is why antibiotic resistance has become a

global scourge: a single doctor or parent is hard-pressed to compromise a patient’s or

child’s health for the sake of people he or she has never met.

 

Insurance is a classic expression of this dilemma. It reduces risk for the person who buys

the insurance policy while raising it for the person selling it. Insurance is usually a dull,

profitable business because most risks are uncorrelated. Life insurance policyholders 

don’t all die at once, and car insurance customers don’t all crash at once. This axiom ofrisk pooling breaks down when risks are correlated, as they are for the worst disasters:

when home prices fall in every part of the country at the same time or thousands of

homeowners are hit by a hurricane or an earthquake simultaneously. That’s when the

survival of the insurance company is endangered and the protection the insurance buyers 

thought they had is illusory.

 

Saving is a form of insurance. Individuals save to guard against economic setbacks.

Countries do the same by accumulating hoards of foreign currency reserves. But for one

person to save, someone else must borrow. If a country as a whole saves too much, it

pushes down interest rates and encourages another country to borrow more, producingdebt-driven asset bubbles and financial crises. If interest rates are already as low as they

can go, a decision by everybody to save more and spend less simply reduces everyone

else’s income and makes the country poorer. This is the paradox of thrift. 

In the face of this irony, what should we do? Can we truly foolproof our surroundings if

we so often cause more mischief in doing so? Or should we be ecologists and allow

natural systems to take their course? At the end of this journey, I concluded that the

answer is neither: we must reconcile the engineers with the ecologists. But how?

Excerpted from the book Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe .

Copyright © 2015 by Greg Ip. Reprinted with permission of Little, Brown and

Company. All rights reserved.