Moral hazard sunk the Titanic

I picked up behavioral economist Dan Ariely’s book The Upside of Irrationality.  I was disappointed to find a pet peeve of mine in the introduction. It basically goes like this (paraphrased):

Road engineers design safety features like rumble strips, sweeping curves and shoulders into roads. Auto engineers build safety devices like seat belts and airbags into cars. They do this because people don’t always exercise good judgement.

Given the 2008 Wall Street implosion, why would we think we don’t need to take external measures — like what the road and auto engineers take — to try prevent or deal with systematic errors of judgement in the mad-made financial markets?

In this analogy, I believe Ariely makes the following links:

  • Auto drivers are like financial markets
  • External measures for drivers are the safety efforts of road and auto engineers
  • External measures for financial markets are regulatory measures

But there’s a couple of problems. Auto and road engineers have competition and they can test their stuff on a small-scale and then roll it out if it works. This is the secret to good innovation.

Regulators don’t have competition and they can’t test their stuff on the small-scale to see if it works.  This is the recipe for unproductive bureaucracy.

I also think Ariely discounts the idea of self-regulation. The 2008 financial meltdown didn’t happen because we lacked the proper external measures. It occurred because we thought we had the right external measures and that created a moral hazard. It was like being careless in steering the Titanic because you believe the ship is unsinkable.

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One thought on “Moral hazard sunk the Titanic

  1. That all makes sense – no matter how safe we try (or are forced) to make things, people will push the limits of safety with a net effect that things are less safe (or at best, no safer). The inevitable conclusion is that we shouldn’t force these “safety” features on people – at least not without carefully looking for unintended consequences. But then we would have more than a few politicians wondering what to do with their free time (they might actually have to work) and how to transfer money from their constituents to their cronies.

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