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Milton J. Madison - An American Refugee Now Living in China, Where Liberty is Ascending

Federalism, Free Markets and the Liberty To Let One's Mind Wander. I Am Very Worried About the Fate of Liberty in the USA, Where Government is Taking people's Lives ____________________________________________________________________________________________ "Extremism in defense of liberty is no vice. Tolerance in the face of tyranny is no virtue." -Barry Goldwater-

Tuesday, April 14, 2009

Regulation causes greater compensatory risk taking?

The Smithsonian magazine has an interesting article on risk compensation where some argue that humans compensate behavior to assume a certain level of risk. The argument, as illustrated by the adoption of seat belts and other safety devices into automobiles has not decreased traffic fatalities and injuries as much as would be expected since the increase in safety devices has allowed (not caused) people increase risky behavior. Furthermore, other areas of risk compensation are illustrated....
The phenomenon has been observed well beyond the highway—in the workplace, on the playing field, at home, in the air. Researchers have found that improved parachute rip cords did not reduce the number of sky-diving accidents; overconfident sky divers hit the silk too late. The number of flooding deaths in the United States has hardly changed in 100 years despite the construction of stronger levees in flood plains; people moved onto the flood plains, in part because of subsidized flood insurance and federal disaster relief. Studies suggest that workers who wear back-support belts try to lift heavier loads and that children who wear protective sports equipment engage in rougher play. Forest rangers say wilderness hikers take greater risks if they know that a trained rescue squad is on call. Public health officials cite evidence that enhanced HIV treatment can lead to riskier sexual behavior.
Glenzo calls the risk compensation phenomenon "the law of unintended consequences." As government foist well intentioned regulations and rules upon the populace, people change their behavior to accept risk in other areas. Some argue that in any endeavor, that people are willing to accept a certain amount of risk and so if risk is reduced in one area, it may raise in other venues.

I think that we can look upon the recent upheavals in the financial markets as a fine example of risk compensation and Glenzo's law of unintended consequences. One may ask themselves if banking has actually experienced a decrease in risk even with the heavy handed regulatory regime foisted upon this business since the 1930's. Banking seems to go through cycles where there are crises every 15 to 20 years or so.

Even when adjusting for government meddling in housing mortgage markets, banks seek risk and the compensation associated with that risk. If there is a banking crisis every 20 years, then bank executives can reap above economic profits by engaging in risky behavior during the good times, get paid for creating these profits and then taking losses for the relatively short periods of crisis.

Or if we think about deposit guarantees by governments where people's deposits are protected from losses in the event of bank failures. This creates an environment where people that make deposits do not differentiate between those banking institutions that engage in risky behavior and those that operate in very prudent manners. Those that are prudent cannot fund in the deposit market cheaper than those that engage in risky or very risky behavior since all deposits are guaranteed by one central agency and therefore carry the same exact risk. So there is a bias towards banks to engage in greater risk since even those that have riskier investment profiles can fund at the exact same cost.

Furthermore, when people these days argue that problems in banking require greater regulations, I think that this is folly. Bankers, given the foundation issues surrounding risk and rewards will ALWAYS find ways to create excess profits and will seek out the shortcomings in regulations and exploit them. They may-or-may not do it consciously but markets will ALWAYS seek excess profits in aggregate and create the systematic risk that these regulation seek to mute.

I argue that we must consider reducing government intervention and regulation and allow the markets to sort out the risk differentials associated with each aspect of the capital markets. There is value differential to the safety of people depositing their money in 'safe' institutions whereas some will seek out excess return by accepting greater risk compensated by greater returns.

I argue that we need to embrace the fact that we are humans, that we behave in a certain way, whether conscious or sub-conscious, and that we will ALWAYS have banking crisis's. When we finally understand this and that governments are incapable in reducing these risks and only capable of changing behavior and sometimes creating sub-optimal behaviors, then we can move forward. The only outcome of the current model is that governments will continue to meddle and risk taking behavior will one day cause even these governments to fail.

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