Three Mile Island, the Challenger Shuttle, and…Lehman Bros.?
Industrial accidents and financial disasters have a lot in common.
"We always blame the operator—'pilot error'", says Charles Perrow, the Yale sociologist. But like a power plant operator staring at the wrong winking light, Geithner had the wrong focus not because he was a fool, but because he was being supplied with information that was confusing and inadequate.
Some economists and regulators have, belatedly, started to focus on this issue of information design. The Dodd-Frank reform act, signed by President Obama in July, establishes a new Office for Financial Research that seems likely to try to draw up a "heat map" of stresses in the financial system. Andrew Haldane, director for financial stability at the Bank of England, looks forward to the day when regulators will have such a map. He argues that the same technologies now used to check the health of an electricity grid could be applied to a financial network map, highlighting critical connections, overstressed nodes and unexpected interactions. "We're a million miles away from that at the moment," he readily admits.
Such a real-time map would certainly help make sense of the new "Basel III" capital requirements for banks. These measures, agreed last September, made provision for additional "loss-absorbing capacity" for "systemically important banks". Well and good, but right now the definition of a systemically important bank is much the same as the definition of pornography: we know it when we see it. That is unlikely to be much help.
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Perhaps the most profound and worrying parallel between preventing industrial catastrophes and financial ones emerges from Perrow's pessimistic theory of "normal accidents". For him, any sufficiently complex, tightly coupled system will fail sooner or later. The answers are to simplify the system, decouple it, or reduce the consequences of failure.
What might decoupling the banking system mean? Consider the slightly obsessive pastime of domino-toppling. One of the first domino-toppling record attempts—8,000 stones—came to a premature and farcical end because a pen dropped out of the pocket of the television cameraman who had come to film the occasion. Other record attempts have been disrupted by moths and grasshoppers. It's the quintessential tightly coupled system.
Professional domino-topplers now use safety gates, removed at the last moment, to ensure that when accidents happen they are contained. In 2005, a hundred volunteers had spent two months setting up 4,155,476 stones in a Dutch exhibition hall when a sparrow flew in and knocked one over. Because of safety gates, only 23,000 dominoes fell. It could have been much worse. (Though not for the hapless sparrow, which an enraged domino enthusiast shot with an air rifle.)
Given the propensity of finance to suffer frequent meltdowns, Perrow's normal accident theory almost certainly describes the banking system. The financial system will never eliminate its sparrows (perhaps black swans would be a more appropriate bird) so it needs the equivalent of those safety gates. Rather than making a particular bank less likely to fail, it might be safer to focus on ensuring that one falling bank doesn't topple other companies.
But few financial commentators have considered the implications of that. One notable exception is John Kay, a British economist and FT columnist, who argues for a system of "narrow banking" which, he asserts, would lead to "a far more robust industry structure, with simpler institutions, less interconnectedness, and greater diversity of industry structure". Another is Laurence Kotlikoff, an economist at Boston university, who has a proposal for "limited purpose banking". Both Kay and Kotlikoff have taken the view that it is worth pursuing a simpler and less tightly coupled financial system for its own sake—in sharp contrast to the prevailing regulatory approach, which unwittingly encouraged banks to become larger and more complicated, and actively encouraged off-balance sheet financial engineering. I do not know whether Kay or Kotlikoff have the right answer. Normal accident theory suggests that they are certainly asking the right question.
This article originally appeared in Financial Times. Click here to read more coverage from the Weekend FT.
Tim Harford is a Financial Times columnist. His latest book, The Logic of Life, will be published in paperback on Feb. 10.