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John Quiggin

Life's a risky business

John Quiggin Australian Financial Review

12 February 2008

Over the last few months, we have been reminded again and again how fragile the foundations on which our lives are built can be. Thousands of people have seen lifetimes of work and savings destroyed by fire or flood, or swept away in the incomprehensible cataclysms of financial markets. Tragically, in the recent bushfire disaster, financial losses have been overshadowed by the loss of hundreds of lives.

And despite technological advances, improved information and organizational innovations, individuals and governments have proved unable to prevent, and only a little to mitigate, the impact of these disasters.

Some of our protections have proved worse than useless. It remains to be seen, for example, whether advice to ‘stay and defend’ homes has discouraged early evacuations that might have saved lives. And it is already clear that derivative assets that were supposed to mitigate and diversify financial risk have actually amplified and convoluted them.

Risk and uncertainty attend everything we do. However carefully we plan, our projects may be derailed by unforeseen contingencies. But we don’t always plan carefully. And, all too frequently, we dismiss ‘worst case scenarios’ as being too awful to think about, rather than carefully considering whether or not they can happen and how to prevent them.

Even when the problems are evident, as with climate change, we shrink from the necessary remedies. It all seems too hard, and there are so many ways to dodge the issue: from the allegedly hardheaded political calculations of professional compromisers to the “Let George do it” irresponsibility of climate laggards to the delusional belief that the whole problem has been made up by grant-grubbing scientists or evil UN bureaucrats.

Matter are even worse when several intractable problems are intertwined. The financial crisis complicates the problem of responding to climate change, and raises questions about the usefulness of market-based responses. Climate change increases the likely frequency and severity of natural disasters such as bushfires and extreme weather events that cause floods. And natural disasters put more stress on insurance companies already weakened by the breakdown of financial markets.

Our current incapacity to respond adequately to our problems can be traced, at least in past, to cultural and political attitudes that developed in many countries, and particularly English-speaking countries, during the 1990s. A series of developments including the return of strong economic growth, the end of the Cold War, and the globalisation of trade and finance on what was essentially a US model,

Pessimistic predictions from environmentalists (most prominently the Club of Rome in the 1970s), from economists concerned about such developments as the growth of current account deficits and from political scientists who saw signs of imperial overstretch seemed to have been (and to some extent were) triumphantly refuted. There seemed to be no problem that could not be solved by a combination of new technology market forces and military power.

For individuals, the rise of the Internet seemed to abolish constraints of all kinds. Princeton University economist Robert Shiller has written about the way the stockmarket boom of the late 1990s was driven by the feeling of mastery obtained when people first use the Internet.

At its worst, the over-optimism of the 1990s has ossified into an ideological and tribal commitment to ignore any information that might cast doubt on the rosy scenarios of triumphalism. This is most evident in relation to climate change. But the same thinking was evident throughout 2008 among those denying that the US economy was in a recession, or in any danger of it.

How can we respond better to the risk of extreme events? One lesson that needs to be learnt is that of the danger of hubris and complacency. The fact that some problem has been successfully managed for a number of years, does not mean it has been solved, and can be ignored. Otherwise success in managing relatively minor shocks can make big disasters even worse.

There are some classic examples of this problem in flood mitigation,. Levee banks that prevent minor floods can reduce preparedness for the rare, but inevitable severe floods that break the banks.

We must also look for better ways to spread risk, so that the costs of extreme events are shared. In doing this, we need to maintain incentives for individual responsibility. Also, as with physical mitigation, it is important to avoid institutions that smooth out small risks while amplifying large ones.

We cannot eliminate risk, or make extreme events impossible. But with a combination of individual responsibility and collective action, we can reduce the severity of such events and share the burdens of their impact.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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