The same policy mistake caused both the Wall Street meltdown and the BP spill.

Making government work better.
June 23 2010 3:00 PM

The Incentives Catastrophe

The same policy mistake caused both the Wall Street meltdown and the BP spill.

Oil spill. Click image to expand.
Oil spill

Incentives matter. In fact, they determine outcomes. It's obvious, but we usually forget this law until after the fact, after the crisis, when we ask almost naively: "Why did they act that way?" The law of incentives is what links the Wall Street cataclysm and BP's ongoing eco-disaster: In each case, we socialized risk and privatized gain, creating an asymmetry that created an incentive for private actors to accept and create too much risk in their business model, believing that at the end of the day, somebody else would bear the burden of that risk, should it metastasize into a disaster.

On Wall Street, as has been all too well-documented and critiqued, the belief that "too big to fail" institutions—from Goldman to GE Capital to Citibank to AIG to Fannie and Freddie—would be bailed out has been proven accurate. Based on this belief, the institutions not only were able to borrow at reduced costs; they embraced leverage ratios and trading models that would have been irrational to parties actually responsible for the downside risk. Unfortunately, this public backstop to TBTF institutions will continue even after the current incarnation of financial re-regulation is passed. The rating agencies even assume this public backstop in their current risk analysis of the still TBTF institutions. Since the banks face exactly the same incentives they have had over the past decade, does anybody believe that they will behave differently?

BP and the other companies drilling in deep water have been offered the same pleasant asymmetry: There is a statutory liability cap of $75 million for ocean spills that are not the consequence of either gross negligence or willful misconduct. That sounds like a big number, but is foolishly small in the context of real-world damages to the environment. There is no cap, needless to say, on the profits that can be derived from the wells drilled. Knowing that they would not have to bear the full risk and pay all the damages that might result from safety lapses—but that they could garner the full upside of profits made by cutting safety corners—BP did precisely what our incentives told them to do. Is anybody surprised, consequently, that BP took on too much risk in the way it drilled, baby, drilled?

Richard Epstein, perhaps the leading star in the constellation of "Chicago school" economists who usually rail against tort damages assessed against corporations, agreed with this analysis recently, observing in the Wall Street Journal that "[t]he legal system should never allow self-interested parties to keep for themselves all the gains from dangerous activities that unilaterally impose losses on others."  A system of litigation permitting parties to recover damages linked to dangerous behavior is designed to force actors to take rational precautionary steps. This system of tort litigation, premised on the obligation and the capacity to compensate injured parties fully, is actually a market mechanism that forces actors to calculate properly likely risks and likely returns. This is often mediated through the obligation to acquire insurance. If the risks are high, insurance will be expensive, and companies will take as many precautions as they can to minimize the possibility of a huge loss in court. Epstein's belief in a tort system requiring full compensation is an intellectually honest perspective—reflecting the market-based foundation of tort litigation.

Yet businesses have often argued—using political sway to be successful—that we must limit their liability, because only by limiting liability will they undertake activity we want to encourage, such as energy exploration. The cost of the insurance or safety steps needed if their damages exposure is unchecked, they argue, is simply too great to make the activity feasible.

A regime of full tort damages and recoveries is one way to balance safety and exploration, or investment and risk, or whatever economic activity we are discussing. But there is another way: meaningful and vigorous oversight to impose safety standards that are dictated not by the market for insurance but by the judgment of serious experts in a regulatory context.

One or the other of these mechanisms must be permitted to exist: exposure to full damages or oversight by tough regulators. The absence of either spells doom. It is no wonder then, that on Wall Street and in the Gulf we have had disaster strike. In each case, we distorted the market by creating an incentive for risk—capping exposure for TBTF institutions and oil drillers and then defanging the regulatory agency that needed to step in to provide the balance we were not letting the market provide.

At a political level, big business over the past 30 years superficially won by limiting liability and neutering the effectiveness of regulatory supervision. And the public has ended up absorbing the enormous costs of two disasters—one financial, one ecological. We will reclaim the proper balance and protection for the public only when we remedy these errors. Eliminate false caps on liability that distort incentives and behavior, or re-establish the effectiveness of the oversight agencies—from the SEC to the MMS. If we don't, the tragedies of the past several years will be premonitions of the crises to come.

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