The Overreactions of Crowds

Speaking recently of the regulatory reaction to the Flash Crash I observed, “In the aftermath of a crisis or accident crowds have an unfortunate tendency to build momentum behind overwrought and foolish responses.”

The WSJ, in discussing regulatory reactions to the Gulf oil spill, notes that this problem has been generally referred to as the “precautionary principle.”

This principle holds that government should attempt to prevent any risk—regardless of the costs involved, however minor the benefits and even without understanding what those risks really are.

In practice such irrational “precautionary” behavior tends to accompany public panics, which themselves seem to be a product of the mass media’s success in fomenting mass hysteria. In any case, the WSJ cites Cass Sunstein as an expert on the problem:

Formerly of the University of Chicago and Harvard, and now the regulatory czar in the White House budget office, Mr. Sunstein calls the precautionary principle “incoherent” and “paralyzing,” as he put it in an essay in the journal Daedalus two years ago.

“Precautions cannot be taken against all risks,” Mr. Sunstein elaborated in his 2005 monograph Laws of Fear, “not for the important but less interesting reason that resources are limited, but simply because efforts to redress any set of risks might produce risks of their own.”

Mr. Sunstein’s insight is that there are risks on all sides of a question—doing nothing can be dangerous, but acting might be more dangerous—so the only rational way to judge regulation is to quantify the costs and benefits. If the Food and Drug Administration took a harder line in approving new medicines, it might protect the public from a future thalidomide disaster. But it could also deprive the public of cures for disease or expose it to serious peril, like having no recourse in a pandemic.

Another Problem Inflation Would Help

Public pension liabilities are the millstone dragging governments into the depths of a sea of red ink, deficits, and even bankruptcy. In a sad twist on this mixed metaphor, it is the pensioners who have managed to tie the millstone to the necks of the “little ones” — the younger generations working to pay increasing taxes to fund exorbitant pension benefits that were promised but never funded.

A few governments have discovered that they might be able to relieve a bit of the weight by reducing “cost-of-living adjustments” (COLA) — especially when those have historically had little or no relation to actual changes in the cost of living. For example, the WSJ notes that Colorado’s pension system had been granting a fixed 3.5% COLA every year to beneficiaries. If the COLA for defined-benefit pensions can be reduced below the rate of inflation, then inflation would gradually erode the real cost of the crushing unfunded pensions.

Of course, only the federal government has the power to inflate the dollar. But faced with a deluge states and municipalities sinking into insolvency under the weight of pension obligations, this would be yet another motive to nudge inflation higher.

(Predictably, pension beneficiaries are using every possible legal maneuver to prevent this. If only they had been so attentive when their unions and politicians were crafting extravagant future benefits to be borne by future generations.)