A View From Above: Chertoff Proposes Role for GovernmentNovember 17, 2008
 Our economy is in crisis mode. We’re over-leveraged. We’re undercapitalized. We’ve ushered in a new era of total deregulation. None of it has worked, and since we realized, we have pumped nearly a trillion rescue dollars into the financial system. According to U.S. Homeland Security Secretary Michael Chertoff, the present financial crisis is following the same mold as two other recent disasters—September 11th and Hurricane Katrina. Despite all of the predictions, we prepared inadequately. “With the passage of time, as the original event becomes a matter of memory, we begin to decide that we're spending too much money trying to avert the risk,” said Chertoff. “And we begin to degrade our preparation once again." To Chertoff, that's "the sign of an inefficient system for managing risk." On October 16, 2008, Chertoff talked with more than 300 Wharton students and faculty in Jon M. Huntsman Hall about "When We Fail to Manage Risk." The event was sponsored by the Wharton Risk Management and Decision Processes Center, under the direction of Wharton Professor Howard Kunreuther. Chertoff looked at our failures to avert risk in the examples of three recent national disasters: September 11th, Hurricane Katrina, and the current financial crisis. Each time a disaster has occurred, we’ve responded in a big way. But each time, we’ve responded with more effort and expense than would have been necessary had we prepared adequately. According to Chertoff, we're living "in the middle of financial woes that have been to some degree…predicted over a number of years, going back into the 1990s — in terms of over-leverage, too much credit, too little equity, [and] home values that are on the tip of a bubble." He says the problem is not that we "failed to anticipate the one-time risk. It's that we don't learn the lesson.” In order to address risk we have to prevent and reduce our vulnerability to disasters, as well as mitigate their consequences by strengthening our preparedness and response. The most important lesson we can draw from these experiences is to focus on the need for strategic, sensible risk management through careful government intervention. While individuals and businesses are still the foundation of a free society and the "fundamental engine of risk management," even "the most ardent capitalist" would agree that the government has a role in making it possible for a free market to function. Chertoff proposes that there are three basic areas where individual risk management seems to fail, and where the government therefore has a responsibility to intervene: time horizons, externalities, and transaction costs. Chertoff contends that the free market overemphasizes short-term benefits and underemphasizes long-term costs. It promotes the attitude that the individual should benefit today, and not worry about possible costs tomorrow. One example of this is the reluctance of people to elevate their homes in flood-prone areas. In order to help society manage risk properly, it is the government's responsibility to create and enforce building codes. The second problem for individual risk management is the tendency to internalize costs to the individual but underestimate costs to society. For example, a factory dumping into a stream may not internalize the costs to everyone downstream. In such situations involving negative externalities, it is the government's responsibility to create and enforce dumping regulations. The third and final problem that the free market cannot solve on its own is the problem of transaction costs. When investors put money into a stock, they trust that it's safe. In order to prevent individuals from having to validate information on their own, the government creates and enforces rules about transparency. "If the disasters and the problems that we've encountered over the last eight years teach us nothing else, it is not only ‘shame on the disaster-maker’ — whether it be mother nature or man— for the first disaster that we don't properly manage, but also shame on us for failing to manage the risk for the second disaster,” Chertoff concluded. “[We must] have the commitment of responsible actors in the government and in the private sector to make sure that we do truly achieve a partnership in managing our risk." The Department of Homeland Security and the Wharton Risk Center have worked closely together over the last year. Secretary Chertoff and Dr. Kunreuther met in January while serving on a World Economic Forum panel on bioterrorism, and since then, DHS and Wharton have collaborated frequently on loss-reduction measures in natural disasters and terrorism. |
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