On low probability-high cost events

Earthquakes, tsunamis, and nuclear accidents are low probability-high cost events.

So are financial crises.

There is nothing we can do to prevent earthquakes and tsunamis.  Sure, with improving technology, we are sometimes able to get a bit of advance warning.  And we can design structures that are more resistant to natural disasters.  For the most part, though, we are at the mercy of Mother Nature.

Nuclear accidents are another matter.  We can decide not to use nuclear power and pretty much eliminate the possibility of a nuclear accident (there is, of course spent nuclear fuel to worry about, and “accidents” that involve nuclear weapons).  Economically speaking, our decision to give up on nuclear power should turn on the costs of *not* using nuclear power, such as greater reliance on fossil fuels and the pollution they cause, dependence on oil producing countries that are neither completely friendly to us nor completely stable, as well as the risks of using nuclear power.

The potential costs of using nuclear power are terrifying.  In the recent crisis in Japan, far more people were killed by the natural disasters than by the nuclear accident, however, the media’s attention has been glued to the nuclear power plant.  This makes some sense, because the nuclear accident could, under the wrong circumstances, be far more devastating for many many years to come.

How about financial crises?

We could as easily eliminate financial crises as we could traffic fatalities on America’s highways.  Reduce the speed limit to 30 miles per hour.  Make everyone drive in a heavily armored car.  And wear helmets.  There would be no need to have motorcyclists wear helmets, because to eliminate road fatalities we would also have to ban motorcycles.

Theoretically possible, but not especially practical.  And there would probably be more heart attacks among drivers, as those forced to drive 30 mph saw their blood pressure rise to stratospheric levels.

Interestingly, we *did* eliminate financial crises–both in the United States and the industrialized world more generally–from the end of the Great Depression through the early 1970s.  It wasn’t that hard to do.  We just imposed what I call a “financial lock-down”–a severe constraining of the activities of the financial sector.

These constraints kept the financial system safer than it has been at any time since the emergence of the modern industrialized state.  Stability came at a price, however, retarding the development of the financial sector as well as economic growth.

For a variety of reasons (i.e., the “Washington consensus,” the power of the financial lobby, the inability to achieve this without concerted multilateral action) we are unlikely to go back to financial lock-down.  Nor, would I argue, that it would be desirable to do so.

Having seen the costs and benefits of both extremes, a financial “lock-down” and a financial “wild west,” I would argue that we need to be somewhere in middle ground.  Precisely *where* in that middle ground is going to be among the most important choices our  regulators and elected leaders are going to have to make.  Let’s hope they choose wisely.

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