It’s human nature to want to improve one’s quality of life. For some, a better quality of life might be to live simply and sustainably off the land, for others a better quality of life is a Harvard education, a seven figure salary, and a summer house in the mountains. Economics has nothing to say about whose quality of life is better, nor should a free society. But what economics does say is that everyone has the same underlying objective and that people will, more often than not, make decisions in ways that help them achieve their version of a better life. This is what the study of economics is really about, how do we achieve all of our wants, goals, and desires for our families, our communities, and our planet with the limited resources that we have to work with? It is a difficult and never ending problem, you might even call it a curse, but it’s what defines us as humans.
As we go through life making choices, we evaluate costs and benefits, both present and future. One of the costs that we are always taking into account is the value (price) we place on risks. Hence, it’s logical to expect people to respond predictably to incentives regarding the price of risk. And herein lies the economic tragedy.
Except for a short period defined by the tech bubble recession and September 11th, the nation’s economy was strong for about 18 years. Since the end of 1991 and until recently, unemployment was never higher than 7.5%, the Dow has grown 215%, per capita personal disposable income is up over 45%, prices have risen on average 1.8% per year, and median home values are up 40%. Historically, the last two decades were pretty good and the relative consistency of these numbers over this extended period led many to believe it could be sustained. “Housing prices always go up,” we were told. “The stock market always returns an average of 8% in the long run,” said investors. Couple this notion with subtle deregulatory policy changes and for many decision makers, the cost of taking on more risk went down.
Businesses took on more risk. Banks took on more risk. Homeowners took on more risk and consumers took on more risk. Some took on the risk of growing too fast, borrowing too much, investing too blindly, and insuring too little. Some risks were naively underestimated while others were fraudulently manipulated and too make matters worse, most were unaware of the “tragedy” that was taking place.
In 1968, Garrett Hardin, a biologist, wrote one of the most cited and read economic articles of all time, The Tragedy of the Commons. In the article, he used simple mathematics and logic to explain how a community with open pasture land (commons) would eventually fall apart because individual farmers were simply making economic decisions to improve their way of life. Each rancher saw that adding one steer to the open pasture yielded benefits greater than costs because the costs were shared by the community. The problem was that individual farmers were not accurately taking into account the hidden costs to the commons. Since all the ranchers were making the same decision, the costs were much higher and eventually there were too many cattle for the pasture to sustain.
As businesses and consumers evaluated the cost of taking on added risk in their own personal decision making, they underestimated the cost caused by others in the economy doing the same thing. Since so many people were taking on added risk, the real hidden cost of risk to the individual decision maker was much higher. Many were making decisions without taking into account the added cost to everyone in the economic system and the tragedy was inevitable.
Like a wild fire, the economy began to burn out of control. Those who miscalculated or manipulated the cost of risk the most were almost immediately eliminated. Others got caught up in the inferno as it spread. But like the aftermath of a forest fire brings new life to the forest floor, the financial crisis appears to be extinguished and as stated by Bernanke “green shoots” are starting to appear.
What should we take away from our latest economic crisis? Like Hardin argued in 1968, some regulation is necessary to protect the commons. He poignantly referred to it as “mutual coercion, mutually agreed upon” meaning that even free markets need publicly agreed upon rules (coercion) that need to be enforced (agreed upon) even though we may not like it.