Financial, Man-made, and Natural Disasters Require Consistent Policy Responses

Last week, my commentary dealt with the analysis underpinning my Senate Small Business Committee testimony (available at www.c-spanvideo.org/program/294781-1). According to my research, the Gulf Coast region will be devastated just under the current six-month moratorium. I estimate that it will lose in excess of 8,000 jobs, more than $2.1 billion in economic activity, and some $100 million in state and local tax revenue. The spill-over effect to the rest of the US could cost 12,000 jobs and nearly $3 billion in lost output nationwide, including $200 million in Federal tax revenues (available at http://www.saveusenergyjobs.com/wp-content/uploads/2010/07/The_Economic_Cost_of_a_Moratorium_on_Offshort%20_Oil_and_Gas_Exploration_to_the_Gulf_Region.pdf).

On Friday, many of you also saw my Wall Street Journal op ed, deriding the spiralling policy rhetoric regarding the gulf and the energy industry (available at http://online.wsj.com/article/SB10001424052748703940904575395303739152376.html?mod=googlenews_wsj). Already, many in Congress are whipping up hostility toward the industry in order to raise taxes to pay for the Administration’s energy legislation.

Having been vocal about what the Administration should avoid, therefore, this week I focus on the policy recommendations that were part of my testimony but not the economic analysis or the op ed. These points are also the basis for a briefing I am providing to a Congressional delegation and other meetings with policymakers in New Orleans on Tuesday.

Whether it is financial or environmental regulatory policy, regulators need to more effectively adapt to innovation and change. Both drilling and financial intermediation technologies have not remained static over the past thirty years. The one certainty, therefore, is change and it is precisely that change in which crises incubate.

Regulating Requires Managing Change…

Of course, it wasn’t established shallow-water technology and procedures that apparently broke down, it was deepwater applications. As in financial services, therefore, regulators need to be responsible for overseeing new technologies and encouraging applications of those technologies on scales corresponding with their established record of experience and safety.

Too often, in both financial services and energy, regulatory investigations are stanched by politicians and officials who demonstrate a vested interest in the outcome. Whether it is the modern-day energy equivalent of the Keating five or just an official who desires a position in industry, the conflict of interests that detract from effective regulation must be addressed.

Regulators, regardless of sector, need not only clear responsibility, but independent authority to act to investigate unfettered on the basis of their own suspicious.

The reason regulators require such freedom is that they are often investigating new applications of technologies (drilling or financial) that – because they are unproven – cannot be deemed safe or risky beyond a substantial degree of error. Nonetheless, the error must be biased in the direction of the social and economic good. That means that we can’t just throw around moratoriums without economic analysis.

…but not Stifling Change

That also means, however, that we cannot rely on further specious applications of the precautionary principle merely in the name of public safety. The success of policies grounded in the precautionary principle depends in large part on policymakers’ ability to place the risks associated with a given industry or product in the proper context. While public safety should be a paramount concern for regulators, absolute certainty about the safety of any item or application can never be scientifically guaranteed.

Applied in conjunction with the scientific method of investigation, therefore, the precautionary principle leads to a logical dead end. Scientific methods hypothesize experimental results based upon theories. An experiment can only support or not support a theory. Hence, the only outcome of an experiment is another theory. No experiment, therefore, can – in and of itself – provide the one hundred percent certainty that is required of the precautionary principle.

Taken in extremis, economists Bob Hahn and Cass Sunstein have observed that “strong versions of the precautionary principle… would frequently eliminate all policies from consideration… because almost all policies impose risks of one kind or another.”  The key, therefore, is to place the risks of any given policy in context, by comparing the risks of a product with the risks posed by its substitutes, and also to weigh the risks of the product against the benefits it creates.

Furthermore, policymakers who ban a known, relatively safe, element may push industries into less well-understood alternatives, the equivalent of jumping “out of the frying pan and into the fire.” For instance, when the EPA attempted to regulate the use of all asbestos, federal courts intervened and over-ruled the regulation. Although asbestos was harmful to humans, alternatives were deemed more dangerous and unknown. In this case the precautionary principle increased risk by forcing unknown, untested substances to be used instead of known commodities. Pushing electric only increases our reliance on batteries laden with heavy metals (which, incidentally, are highly recyclable but for which we have no mandatory recycling program), solar that requires precious fresh water supplies for chip manufacture, and wind that kills far more birds regularly than the occasional oil spill.

Crisis Response is different from Re-regulation

Moreover, as long as we will be regulating new technological applications we will never have complete and unmitigated success. Hence, we will always be responding to supervisory failure and crisis and we must therefore become comfortable doing so. Whether it is financial or environmental disaster, we first need to audit our approaches to the proximate causes of the disaster, separating those that work from those that require remediation. Then, we must reward businesses operations based on prudent safety and technological standards, while punishing those who operate otherwise. Such an approach not only preserves economic activity and business investment, but provides incentives to direct investment rationally toward safe and sound applications of technology and away from socially harmful alternatives.

In summary, we need to be careful to preserve capitalism while acting, occasionally, where markets cannot. In such actions, however, we want to preserve, not usurp, market functions by helping align incentives so that markets can effectively magnify the effects of policy. All too often, however, poorly designed policy is obviated by markets, as firms contort their operations to meet the letter – while obviating the intent – of specific outdated and onerous regulations, as is already happening among the five hundred new financial regulations.


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