TCS Daily

Risk and Animal Spirits

By James K. Glassman - January 1, 2005 12:00 AM

Editor's note: The following remarks were delivered at the Risk: Regulation and Reality Conference by James Glassman, founder of TCS. The conference was co-hosted by Tech Central Station and was held on October 7, 2004 in Toronto, ON.

James Glassman: Thank you. It's great to be here today. I'm going to just say a few words, well, a few words meaning maybe 20 or 25 minutes worth, and then we're going to proceed through the rest of the conference.

A year and one-half ago at the Royal Institution in London where Michael Faraday conducted his spectacular experiments in physics and chemistry, Tech Central Station conducted an experiment only slightly less daring. We dared to assert that Europe was too frightened of taking even sensible risks and was thus harming its own economic wellbeing and health in limiting human freedom. Europe has become a profoundly conservative society paralyzed by something called the precautionary principle, and Canada, and, yes, the United States, are not far behind. That's why we are here today in this beautiful city of Toronto on this absolutely gorgeous day.

Risk taking is at the heart of the animal spirits, that's a Kansas term, that have helped to free market economies prosper as imagination thrives. To take a risk is to expose yourself to danger. The management of risk is what great insurance companies and financial services firms do for a living using techniques pioneered by Paschal in the 17th century. We're all, of course, in the risk taking business, the risk management business. We walk across the street, decide whether we want to take an umbrella, bet on the lottery, we are, in a sense, managing risk.

Our main concern today, however, is how regulatory policies of governments try, often in destructive and counterproductive ways, to dampen risks. Technology has the potential to increase prosperity and liberty enormously, which may be why government and interest groups want to limit biotechnology, revolutionary software, new drugs, vigorously competitive businesses, the Internet itself, always in the name of stifling risk when really we often want risks to run. Even in the best of cases we can't be sure of the extent of every danger, but we take reasonable risk, it is part of our humanity. To deny the ability to take risk is to crush basic freedoms.

The precautionary principle, which is at the heart of much government regulation, is a political idea, it's not a scientific theorem. The precautionary principle has no official definition, of course, but the wingspan declaration by a group of environmentalists in 1998 is generally accepted, at least in the NGO community. And it goes like this, when an activity raises threats of harm to human health and the environment, precautionary measures should be taken even if, even if some cause and effect relationships are not established scientifically. In other words, forget the science, as Mick Hume of, which is a wonderful British-based website, put it, the precautionary principle is humanity's most powerful self-imposed constraint.

In 2002, I was in South Africa for a conference, and, at the time, a famine was sweeping through Southern Africa. The United States sent huge amounts of basic food to feed the starving. Much of the corn that was sent was grown through methods involving genetic modification or GM as the majority of corn in the United States is. Green groups ruled by the precautionary principle persuaded the president of Zambia and other leaders of effected countries to reject the aid, to let their people starve in order to avoid an imaginary risk. The GM food stayed in warehouses in Africa and in an absurd catastrophe people died because of the precautionary principle. It can kill.

The effects of the precautionary principle are not always evident. That's because it is an example of a distinction that was identified by the great 19th century economist, French economist, Frederick Bastiat, the distinction between the seen and the unseen. This is an idea that all economic activities, in fact, all actions related to public policy have effects that are both evident and not evident. The latter may be more important. What great discoveries, inventions, applications, won't emerge because of the precautionary principle and excessive fear of risk taking? We can't possibly know the answer to that question.

Recently, 40 members of the international scientific community were asked to identify historic achievements that would have been thwarted by the precautionary principle. Among them, the airplane, air conditioning, blood transfusion, high voltage power grids, nuclear power and the discovery of America. The editor of The Journal Energy and Environment wrote, virtually all scientific and technological discoveries would be thwarted because all create, initially, at least, powerful losers who can agitate the ideological and political system against the new.

Take drugs, I don't mean take drugs right now, but, just consider drugs, the FDA, the Food & Drug Administration of the United States, which is important to Canadians since a great number of the drugs that you take are made by U.S. firms, decided 40 years ago that a drugs efficacy, that is to say whether it works or not, and not its safety, be confirmed before a drug is sold. Sam Peltzman, who is a great economist who studied this issue, wrote, the 1962 legislation basically says to a drug developer, if you want to claim that your new drug does something, you will have to prove that to the satisfaction of the FDA before you can sell the drug.

Now the intent of this is laudable on the surface. Ineffective drugs can waste money and precious time for more beneficial treatments. But the tests required to prove efficacy to the FDA take time, whether the drug ultimately passes the test or not. This extra time is measured in years, in fact, in many, many years rather than in months or weeks. And, in some cases, it is a cost that is well spent. Some ineffective drugs are screened out and the extra testing catches some that are dangerous as well. But every effective drug that ultimately makes it to market also incurs a time cost, including some time that can save lives or relieve the suffering of illness. In these cases the extra time means that some potential beneficiaries of the drug will die or suffer while the FDA sifts the test result.

Now Peltzman says that his reading of the available evidence was simply that this latter cost far outweighs the benefit. Indeed, he writes, the death toll from this regulatory delay can easily number into the thousands per year. By contrast, the benefits are small. He found that the unregulated market was very quickly weeding out ineffective drugs prior to 1962. Their sales declined rapidly within a few months of introduction and there was little room for regulation to improve unmarked forces. Now this drug experience makes an important point about risk. Government's attempts to limit it frequently do more harm than good.

Another example is the Endangered Species Act. I know you have one in Canada. The one in the United States passed in 1973. There have been several academic studies of this issue. Let me just address one of them, which was a study by Loueck and Michael of the Red Cockaded Woodpecker. Now the Red Cockaded Woodpecker is an endangered species that lives in Southern forests with commercial value. Such forests were normally allowed to grow until it becomes economically feasible to cut down the trees and to clear cut them, some are clear cut, some might ultimately be clear cut and others are thinned gradually. Some of the clear cut forests will be replanted and others will not. The Endangered Species Act changes all these calculations. If you own a forest, which is a habitat for Red Cockaded Woodpecker, you cannot cut down the trees. You're not allowed to cut down the trees. Now that's good for the Woodpecker, but the birds move around. So if you own forest land that is near the birds habitat, your incentive is very, very clear. Cut down the trees now. If you wait, your land is going to become the habitat for the species. So the Endangered Species Act actually encourages, in many cases, exactly the kind of behavior that is probably not good for the environment.

Many other examples, Peltzman, for example, sites mandatory safety equipment in automobiles. He shows that research indicates from 1925 to 1960 when there was no mandatory safety equipment on cars auto fatalities dropped 3.5 percent per mile driven annually, annually, that's without government rules. Since then, since seat belt laws and so forth, deaths have dropped annually 3.5 percent as well. Why? Why not more with the new rules? Because of what he calls a rule of offsetting behavior. When you have seatbelts, or when you have a safer car, you think it's safer; you are willing to take more risks like driving fast. The net effect is exactly the same in this case as if there were no government regulations at all.

But why do we improve, why is it that our ability to take risks and not get hurt declines? That's something Peltzman calls, borrowing from Adam Smith, the natural progress of opulence. As nations get richer, they get safer without government intervention. Wealth makes health. The best example of this is Kyoto.

You're going to hear today from my colleague, Sallie Baliunas, the co-host of Tech Central Station, and a research associate at Harvard University in the field of astrophysics. There are two on this subject, to a much greater length, there are two problems with climate change mitigation, Kyoto style. First, there's a lack of sound science behind predictions of calamitously rising temperatures over the next 100 years. More and more research lately is casting doubt on the computer models that predict the change. In a study led by Dr. Baliunas and her Harvard colleague Willie Soon [ph.], found last year that according to most studies the 20th century is not the warmest century on record. Long before there were SUVs, 1000 years ago, the Vikings were cultivating Greenland, temperatures move in cycles, perhaps influenced by solar activity, we don't know at this point, but the extent of the human role in climate change is sheer conjecture. Second, cutting greenhouse gases, gas emission, is extremely costly since the only way to do it is to reduce the use of fossil fuels. Since those fuels are the inexpensive leverage that allows an economy to grow, cutting down on them can be disastrous to worldwide economic growth. It is economic growth, which, in an effect called the Kuznets curve, improves environments. As nations get richer, they get safer and healthier and their environments improve. Tons of economic data on this.

Poverty is the worst polluter said the late Indira Gandhi. The precautionary principle is a great encouragement to poverty and to absurdity. You can now consider the case of smokeless tobacco. You are going to hear this story later today from Michael Kunze of the University of Vienna who has said that public health regulation must be evidence-based.

Now that doesn't sound like a radical idea, however, at a time like this it is almost revolutionary. Smokeless tobacco has been banned in the EU with the exception of Sweden and in Australia, while cigarette smoking, despite its proven harmful effects, remains legal in those parts of the world. Now I am not advocating that cigarettes be banned, I just find it absurd that the precautionary principle should apply to the non-proven activity and not to the proven activity.

Let me touch briefly on financial risk. In the wake of the Enron and WorldCom scandals in the United States and smaller scandals involving mutual funds, steps to build confidence among investors and reduce risk were taken by politicians, but, actually, many of these steps have increased risk. For example, the risk of suffering from an inadequately funded retirement, many of the measures raise costs and diverted the attention of managers, reducing earnings from where they should have been. Also, these steps sent the wrong signal. Politicians are telling investors, if you lose money in stocks, you've probably been cheated and we'll protect you, don't worry.

Now the truth is, the stock market is risky, but there are good portfolio management measures like smart diversification that can reduce risk. Market measures, these are market measures, not government measures. And by stepping in, government creates a kind of moral hazard, actually encouraging more reckless behavior, but let me add also that markets are more powerful than governments in disciplining miscreants.

In 2003 and the first half of 2004, two of the large mutual funds in the United States that were involved in scandals, Putnam and Janis [ph.], suffered a net outflow from investors of $70 billion, while two companies that were untainted, American Funds and Van Guard, had net inflows of $188 billion. Investors saw what happened, took their own steps.

Does government have a legitimate role in reducing risks? Absolutely, in enforcing laws against fraud, for example, or any law that protects against theft or injury. Those are real risks, and, in most cases, only an armed authority can properly protect against them, but in regulation of risk government must proceed in a gingerly fashion. Its actions must recognize what Peltzman calls offsetting behavior, as in the case of endangered species or auto safety rules. It must recognize that moral hazard in the case of financial rules that can actually increase risk rather than reduce it. These actions must respect sound science as government does not in areas like smokeless tobacco and climate change. The measures must look at the cost of risk reducing regulations and measure them against the potential benefits, recognizing that to try to reduce risk is in many cases a blow to human freedom, as we will hear later today from Radley Balko, and these actions must be taken with the full realization that prosperity, prosperity itself reduces risk. As Adam Smith said, through the natural progress of opulence and the measures must be taken with full understanding that regulations can dampen economic growth and can be dangerous to wellbeing as in the case of Kyoto and financial regulations.

Canadians, in fact all of us, will never be able to make the right choices, to learn responsibility, to enjoy liberty if the nanny culture pervades our lives. Look at the ruckus over obesity. If ever there was a risk that people understand, this is it. If you eat a lot of fattening food you're going to get fat, if you don't, especially if you don't exercise. If ever there was a problem that's amenable to personal choice, this is it, and yet people are urging government to step in and reduce personal responsibility.

Risk taking, as I said earlier, is at the heart of the animal spirits that have made free market economies prosper as imagination thrives, but government, in league with environmentalists, political groups, special interests, and often the media, is using that possibility of risk as a way to reduce, to limit freedom.

Technology has the potential to increase freedom exponentially, which is why government and the sycophants and cynics who try to use it for their own selfish ends want to limit biotechnology, revolutionary software, new drugs, financial innovation and the Internet itself, and that is why the conference today is so important. By exposing the irrational obsession with risk, this conference will promote freedom and prosperity and unleash the imagination of Canadians of us all. I thank you for listening. [Applause]


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