The windows of heaven opened over the Mississippi River basin in early April 1965, and rain was upon the land for half a month. It fell on soil hardened by an unusually deep winter frost and streams swollen with the melt from a heavy, late snow. On April 5, the Mississippi began rising rapidly in Minnesota, Wisconsin, and Iowa. Governors deployed the National Guard to build and patch dikes.
The river swept away houses or beat them to sticks, according to witness reports compiled by the National Weather Service. On April 16, Good Friday, surging waters broke through railroad tracks in Bluff Siding, Wis., and raced over thousands of acres of farmland, flinging dazed livestock across the countryside.
From north of Minneapolis down to Hannibal, Mo., the waters climbed to heights that still stand as records. The raging Mississippi inflicted what would be $1.5 billion in damages in today’s dollars, a tab largely picked up by the federal government, because most of the farmers lacked flood insurance. It was a level of destruction that few townsfolk along the river had thought possible.
As Charlie Hale, a photographer who snapped hundreds of rolls of flood photos for the Post-Bulletin in Rochester, Minn., later recalled to the Weather Service, “Old-timers couldn’t remember any floods big enough to flood a city—why should 1965 be different?” His camera told Hale it was different. Flying over the Mississippi in early April, he likened the river to “a time bomb,” and said he wondered “if it was going to get the right elements and explode someplace.”
People build houses on floodplains because they expect that someone will rescue them if things go bad. That’s the classic economic parable of “moral hazard,” the tendency of individuals and institutions to take on too much risk whenever they don’t have to pay for it. It’s also one of the simplest ways to explain how the U.S. economy tanked three years ago and why it remains in danger of collapsing again, even more catastrophically.
The river-dwellers in the 1960s, who undervalued risk, presaged the investment bankers and subprime-mortgage borrowers in the run-up to the financial crisis. After all, what kind of society turns its back on families left homeless by a flood, or lets its system of borrowing and lending disintegrate overnight?
When a monster flood strikes, the government typically passes laws designed to prevent a repeat of the destruction. Fairly quickly, though, houses start popping up on the floodplain again. That was true along the Mississippi River basin. After the 1965 floods, President Johnson pushed through a set of reforms that included the first federal flood-insurance program. In 1993, the river spilled over its banks again. Damages topped $22 billion in today’s dollars, about 15 times the real-dollar amount from 1965. Once again, the government bore much of the cost. Few locals had bought what was supposed to be mandatory insurance.
The U.S. economy is in danger of a much more devastating déjà vu event today—unless regulators, lawmakers, businesses, and consumers adjust their actions to account for new risks and the nation’s increased vulnerability to them. Protecting ourselves starts with admitting that the next big storm could hit soon and that, if it does, rescue could be a long time coming.
The waters are just now receding from the financial flood of 2008. But the river remains, as photographer Hale said, filled with time bombs. The increasingly connected international economy, the rapidly changing global ecology, and the world’s dizzyingly complex and distressed financial system all carry risks that could explode and wipe out the U.S. recovery. Meanwhile, the lingering effects of the last crisis have weakened wealthy nations’ ability to respond to the next one if it comes soon.
It’s difficult to pin down the total burden of risk that the economy is bearing, or to say with any certainty whether Americans are taking more inadvisable risks today than in the past. But what’s indisputable is that the American economy is highly vulnerable, perhaps more so than at any point in recent history, to the threat of risky behavior blowing a hole in its fragile recovery. It’s also true that the underpriced risks taken today by an overconfident few—highly leveraged foreign banks, say, or fossil-fuel gluttons in industrial countries—could rain economic misery on the masses in the United States and around the world.
In other words, whether we choose to or not, we all live on a floodplain now.
A PERILOUS ECONOMY
Economic risk isn’t inherently bad—nations couldn’t grow and prosper if people never took chances with their money. In a free and functioning market, problems start when risk is priced too low, forcing everyone unwittingly to share in the resulting vulnerability.
If Jane wants to buy a house with money borrowed from her bank, the bank estimates Jane’s risk of default and charges her appropriately to cover that risk. But what if the lender gave Jane a discount, assuming that her neighbors would step in to help make payments if she faced losing the house? So, what if Jane got a loan she really shouldn’t have qualified for? And what if Jane and all her neighbors, who also borrowed from the bank at discount rates, defaulted at the same time? What if the bank then fails, and no one in town can borrow money, and the local economy collapses? A lot of people with no connection to Jane or her loan suffer the consequences.
The financial crisis showed just how wicked such a chain reaction can become and how many bystanders it can hurt. In its aftermath, governments around the world pushed for reforms to minimize the chances of a repeat meltdown. But policymakers failed to shore up critical vulnerabilities that lurk in the system—areas where risk is underpriced and thus over-embraced. Those are the potential triggers of the next crippling chain reaction.
“The problem is, we didn’t change much of the structure, and we didn’t change much of the regulation of the risk market,” says Christian Gollier, an economics professor at the University of Toulouse and the head of the social decision-making program at Georgia State University’s Center for the Economic Analysis of Risk. “My impression is that the risk has not been reduced after the crisis—quite the contrary.”
Gollier was one of more than two dozen economists who agreed to talk to National Journal about pinpointing the “time bombs” of incorrectly priced risk that pose the greatest threat to the U.S. and global economies. A few mentioned terrorist attacks, nuclear warfare, or science-fiction-style terrors such as asteroids or rebellion by sentient computers. But most respondents focused on two broad—and decidedly more concrete—categories: financial and environmental risk. A third frequent suggestion, the risk of a precipitous spike in oil prices, bridged the two.
Economists and lawmakers hotly debate the degree to which the United States has defused its financial risks. Perhaps the best way to think about the crash’s aftermath is that government officials did all they could have been expected to do but not everything they needed to.
In the wake of the financial bust, U.S. and world leaders adopted a series of stricter rules for financial institutions to guard against risky behaviors that could bring the system to its knees. They agreed to raise the amount of capital that banks are required to hold, through the so-called Basel III agreement. That higher bar is an attempt to shore up a business model that matches often-illiquid assets with cheap, short-term financing. When the value of the assets falls unexpectedly, as it did quite infamously with Lehman Brothers, financial institutions cannot afford to pay their short-term debts—unless they have a sufficiently large cushion of capital.
Some economists worry that the real-estate market, despite price plunges, remains artificially inflated and in jeopardy of further collapse.
Problem is, many economists contend that it remains relatively easy for financial institutions to elude those capital requirements. That’s particularly true among the large foreign-owned financial institutions that buy U.S. Treasury bonds and make up much of the Federal Reserve Board’s “primary dealer” market. Many of those institutions have restructured their holdings to keep their seat in the market without actually complying with the increased capital standards, says Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who is now the chief monetary economist for Cumberland Advisors.
Such evasion leaves the United States exposed to a domino-like rerun of the last crash. If asset prices plunged, debts were called in, and several primary dealers failed at once, the federal government’s ability
to borrow would evaporate. Eisenbeis and others say that this risk gives the government a vested interest in keeping the dealers solvent, reinforcing the “too big to fail” mentality that incents the financial giants to risky behavior.
Other reforms, including the Dodd-Frank financial-regulation bill, were designed to shine a light on the risky assets in financial institutions’ portfolios. But as the law is being implemented, it’s still far from clear how much risk individual institutions—including the nation’s largest banks—are carrying. The 10 largest U.S. banks now hold a bigger share of total bank deposits, handle a bigger share of financial transactions, and buy a bigger share of U.S. Treasuries than they did before the crisis.
Alth0ugh the financial-reform law attempts to fix that risk by regulating the “systemically important” institutions much more tightly, these giant banks are fighting to wriggle free, with some support on Capitol Hill. Transparency remains a problem with regulators, too: The next round of the Federal Reserve’s vaunted “stress tests” of large banks’ ability to withstand a crisis is widely expected to result in passing grades across the board, with little documentation to back them up.
“The soundness of the largest financial institutions and the systemic risks they continue to pose is no better” than it was before the crisis, warned Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, Mo., in a speech on February 23. “In my view, it is even worse.” Hoenig, a conservative, argued that the only way to reduce risk would be to prohibit banks from trading their own accounts in the securities markets.
Some economists also warn that Dodd-Frank does not go far enough to regulate capital-poor, risk-rich “shadow banks,” such as investment banks and hedge funds, and to prevent the shadow-banking collapses that fueled the financial crisis. “We’re not dealing with the capital problems in these large institutions,” Eisenbeis says. “If you have sound financial institutions, you can weather a storm in a way that you couldn’t otherwise.”
Moreover, in spite of a pricing plunge that continues in many metro areas, the real-estate market remains artificially inflated and in jeopardy of further collapse, a number of economists say. That’s because Washington stepped in to stop the market free-fall by taking receivership of mortgage-lending giants Fannie Mae and Freddie Mac. As a result, the government is now underwriting 95 percent of residential loans and essentially using taxpayer dollars to guarantee against default.
Lending standards have tightened some, and the Obama administration is pushing to tighten them even more, but economists say that the mere presence of a government backstop induces overly risky behavior. That leaves Congress and the White House with a grim choice: Keeping some form of government guarantee in place could set off another wave of bad loans, yet quickly removing the guarantee could send housing prices into yet another heart-stopping fall. “There’s a sense in which the housing risk, which really brought down the financial sector, has been transferred to the government,” Viral Acharya, a finance professor at New York University’s Stern School of Business, told NJ. “But the risk has not been fixed.”
The Obama administration, it is fair to note, is far more optimistic that the crisis and ensuing reforms have gone a long way toward reducing undue risk in the financial sector. Officials say that capital levels have improved dramatically from precrisis levels, housing loans are harder to come by, credit in general is of higher quality, and further implementation of Dodd-Frank will brighten the picture even more. “The core of the American financial system is in a much stronger position than it was before the crisis,” Treasury Secretary Timothy Geithner told reporters at a Bloomberg breakfast late last month.
Ordinary Americans are the inadvertent bearers of financial risk. After all, relatively few work on Wall Street or take out loans they can’t afford. But environmental risk is something Americans inflict on themselves—and on the world. The mother of all environmental risks is climate change. As greenhouse gases collect in the atmosphere, the odds increase that the planet will experience dramatic rises in temperatures, sea levels, and extreme weather events such as droughts and floods. Any of those changes will come with enormous costs.
Under many frighteningly plausible scenarios for a climate-altered future, increasingly frequent heat waves will drive up Americans’ air conditioning and medical costs and threaten the lives of senior citizens. Wilting or flooded crops across the Great Plains will plunge farmers into financial distress and push grocery prices up. Western states will scrape and fight for disappearing water reserves, and the winners will pay through the nose. Erosion and rising seas will force millions of coastal residents to relocate inland.
The most frightening risk is that the effects could come much more quickly and severely than scientists forecast in their most probable scenarios—disrupting food supplies, displacing large swaths of the population, and setting off a feedback loop of greenhouse-gas release that could prove nearly impossible to stop.
Economists offer a wide range of figures for what the drivers of gasoline-powered automobiles, the consumers of coal-fired electricity, and other fossil-fuel burners should pay to offset the climate risks they are taking. The Obama administration, in an annual economic report issued in February, pegged the “social cost of carbon” in the range of $5 to $67 per ton of carbon dioxide. America is liable for mean damages of $1 trillion over the next 40 years because of climate change, according to researchers at Sandia National Laboratories. Factor in the low-probability, high-impact risk of a catastrophic climate shock, other economists say, and the premium could be substantially higher.
“This problem belongs to a very small class of phenomena where it’s very difficult to put a bound on the damages, because the whole planet is involved,” says Martin Weitzman, a Harvard economist who studies the pricing of climate risk. Complicating matters further, he adds, is the inability of Americans—and most other residents of democracies—to weigh the potential far-off costs of their actions today. “The average person throughout the world does not see climate change impacting their daily life,” he says. “It’s just too hypothetical.”
Washington divides deeply on partisan and regional lines over carbon policy, with the most entrenched opponents even challenging the premise that climate change is, in fact, real. As a result of the stalemate, the effective price of climate risk in the United States is zero. That means we’re taking on too much of it.
“There’s a sense the housing risk … has been transferred to the government.” —Viral Acharya, New York University
We’re also putting a lot of bystanders in harm’s way, including island nations vulnerable to rising oceans and farmers in developing countries whose subsistence crops could dry up with too little rain or wash away with too much. The bystander effects pose a risk by themselves: Food shortages, in particular, can fuel political upheaval and disrupt the lines of global commerce on which the U.S. economy increasingly depends. Witness the Middle East this year.
America’s more immediate economic risk in the Middle East flows from oil and the chance that spreading protests could slow production to a trickle across the Arabian Peninsula. Presidents dating back to Richard Nixon have warned of the risks of foreign-oil dependence, but American consumers are not paying anything close to the full costs of those risks. We have driven our cars
too much and invested too little in meaningful alternatives to petroleum-based transportation. Now we are just hoping to dodge a catastrophe.
If unrest on par with Egypt’s or Libya’s breaks out across Saudi Arabia, disrupting supplies from the world’s largest oil exporter, analysts say that crude prices could soar past $200 a barrel. That’s $6-per-gallon-of-gasoline territory in the United States, and a sure prescription for a dip back into recession.
Every post-World War II economic downturn in the United States except one has followed a surge in oil prices, according to economist James D. Hamilton of the University of California (San Diego), one of the nation’s foremost experts in oil-price shocks. “The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence,” Hamilton wrote in a research paper released in January, adding that “supply disruptions arising from dramatic geopolitical events are prominent causes of a number of the most important episodes.”
The math is straightforward. Because Americans remain locked into dependence on oil for transportation—a dependence enabled by comparatively low gasoline prices in flush economic times—the United States has few immediate recourses when prices spike. The more gasoline costs, the larger the share of their incomes Americans spend on it, and the more U.S. assets flow to oil producers overseas. That leaves less money to spend on everything else in the domestic economy. Right now, the U.S. needs all the consumer spending it can get as it climbs gingerly toward robust economic and job growth. But as oil prices have risen amid the Middle Eastern unrest, gasoline’s share of the spending pie has ticked up, too.
If prices skyrocket and divert huge amounts of consumer spending, and if the economy turns down again, the next recession will be deep—and the climb out from the recent financial crisis will seem easy by comparison.
Nearly every economist National Journal interviewed noted how extraordinarily vulnerable the United States, and the industrial world with it, is to events that at any other time might not prove catastrophic. The simple reason is that everyone is tapped out. Countries racked up enormous deficits attempting to borrow and spend through the recessionary cratering of consumer demand. In the same pursuit, central bankers cut interest rates to near (or, effectively, below) zero. So not much fiscal or monetary stimulus will be available if another crisis hits in the near future. Instead, loose money and large deficits could spark a stagflation cycle of negative growth and rapid price increases.
By far the most talked-about crisis risk in Washington is the possibility that mounting debt will sink the U.S. economy. That risk is priced by what appears to be a fair and transparent market in sovereign debt and credit-default swaps, where investors continue to regard U.S. debt as safer than almost any other country’s. But some analysts worry that markets are underestimating the risks of a debt crisis. By any measure, America’s mounting debts would almost certainly make another crisis much tougher for governments to handle.
If this sounds disheartening, it is. Americans don’t have to bear the burden of underpriced risk forever, though.
First, the country must tackle its moral-hazard problem. That means, economist say, spelling out, in iron-clad terms, the limits of government intervention in the economy. Jane’s neighbors must tell the bank that they will let her lose her house, no matter what, if she defaults. That tough love is easier said than done, of course, and it’s not always popular.
One analysis shows that every post-World War II economic downturn in the U.S. except one has followed a surge in oil prices.
Some interventions are out of America’s control, such as whether a foreign government will bail out an overseas bank that is a primary dealer in U.S. Treasuries. Others are hemmed in by politics. It’s easy enough to forbid rebuilding on the uninsured floodplain, in theory. When cable news is awash in video of shivering families searching through the splinters of their demolished homes, it’s harder to say no.
Second, if individuals and markets can’t or won’t adequately price the risk of certain behaviors, someone must aggressively manage it. We must require higher down payments and stricter credit standards for mortgage borrowers. We must enforce more-stringent capital requirements for shadow banks, without loopholes.
For inspiration, look to Coca-Cola. Two years ago, the world’s largest beverage vendor began declaring a new risk in its annual filing with the Securities and Exchange Commission: “Climate change may negatively affect our business.” It was a simple H2O problem. The company relies on water for its bottling plants across the globe, and it was beginning to worry about the supply. Executives noticed that droughts that typically would have lasted six months were persisting for three years; 500-year floods were recurring once a decade.
“Without water, we don’t have a business,” says Jeff Seabright, Coke’s vice president for environment and water resources. “If you sort of look at the climate science, the way in which global climate change is being manifested on the planet is through the hydrological cycle.” Later, he added: “You can’t predict the future, but you can prepare for it.”
Led by Seabright, and in partnership with the World Wildlife Fund, Coke has launched a corporate-sustainability plan to adapt to extreme weather and nail down less-vulnerable water sources. The company has dramatically reduced its carbon footprint and led industry pushes to reduce deforestation and the use of refrigerant hydrofluorocarbons, or HFCs, both major contributors to greenhouse-gas emissions. Coke’s chairman led a delegation of CEOs to the climate negotiations in Cancun last year to urge world leaders to impose a price on carbon.
Environmental economists and some conservation groups are increasingly hopeful that a risk-based pitch for climate action could sway conservative lawmakers who have adopted near-uniform doubts about the validity of climate science. You don’t have to believe that economically painful climate change will happen to embrace that view; you just need to agree that it could happen. Then we all can tussle over the odds and the appropriate price. Anyone who says that the right price is “zero” risks comparisons to the farmers who refused to believe that the Mississippi could ever flood their fields.
“You get into this debate with people about the certainty of the science, and it entirely misses the point,” says Carter Roberts, president and CEO of the World Wildlife Fund. “It’s not about certainty. It’s about uncertainty. And the uncertainty’s the risk.”
The final step to a healthy risk relationship is some soul-searching. Americans should ask themselves, and their neighbors, whether overconfidence is clouding their risk perceptions. Writing about the financial crisis in his recent e-book, The Great Stagnation, economist Tyler Cowen of George Mason University concludes that “many millions of people were complicit, whether intentionally or not,” in the risks that led up to the crash. The possibility that the financial system would go bad was always there, Cowen writes. “For the most part, we as a society let this possibility slip because we felt so invulnerable.”
Gollier, the Toulouse economist directing Georgia State’s social decision-making program, has, along with several colleagues, advanced a theory that people manipulate their own beliefs to maximize their present welfare. “You know the truth, but you don’t want to believe in the truth,” he says. “You change your mind.” Your risk perceptions change accordingly. You downplay the possibility of contracting lung cancer because you enjoy the pleasure of smoking. You up your optimism about stock-market performance
and invest in an overly risky portfolio so you can reduce the amount of money you save for retirement.
Of all the steps the United States needs to rebalance its risk approach, the most important might be honesty. We need to stop pretending we live on the high ground. The first move in disaster prep is to recognize you’re on the floodplain. That’s especially true now, as the national economic outlook looks sunnier than it has for a couple of years. It would be tempting to stow the hip waders and break out the flip-flops. But be careful. Don’t rule out more rain. Weather’s been awfully strange lately.
Clifford Marks contributed
This article appears in the March 12, 2011, edition of National Journal.