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Tuesday, June 01, 2010

Rogoff: The BP Oil Spill’s Lessons for Regulation

Kenneth Rogoff frets over our ability to regulate complex emerging technologies:

The BP Oil Spill’s Lessons for Regulation, by Kenneth Rogoff, Commentary, Project Syndicate: As the damaged BP oil well continues to spew millions of gallons of crude..., the immediate challenge is how to mitigate an ever-magnifying environmental catastrophe. ... The disaster, however, poses a much deeper challenge to how modern societies deal with regulating complex technologies. The accelerating speed of innovation seems to be outstripping government regulators’ capacity to deal with risks, much less anticipate them.
The parallels between the oil spill and the recent financial crisis are all too painful: the promise of innovation, unfathomable complexity, and lack of transparency (...we know only a very small fraction of what goes on at the oceans’ depths.) Wealthy and politically powerful lobbies put enormous pressure on even the most robust governance structures. It is a huge embarrassment for US President Barack Obama that he proposed – admittedly under pressure from the Republican opposition – to expand offshore oil drilling greatly just before the BP catastrophe struck.
The oil technology story, like the one for exotic financial instruments, was very compelling and seductive. Oil executives bragged that they could drill a couple of kilometers down, then a kilometer across, and hit their target within a few meters. Suddenly, instead of a world of “peak oil” with ever-depleting resources, technology offered the promise of extending supplies for another generation. ... Some developing countries, most notably Brazil, have discovered huge potential offshore riches.
Now all bets are off. ... Will Brazil really risk its spectacular coastline for oil, now that everyone has been reminded of what can happen? What about Nigeria, where other risks are amplified by civil strife? ...
The basic problem of complexity, technology, and regulation extends to many other areas of modern life. Nanotechnology and innovation in developing artificial organisms offer a huge potential boon to mankind, promising development of new materials, medicines, and treatment techniques. Yet, with all of these exciting technologies, it is extremely difficult to strike a balance between managing “tail risk” – a very small risk of a very large disaster – and supporting innovation.
Financial crises are almost comforting by comparison. Speculative bubbles and banking crises have been a regular feature of the economic landscape for centuries. Awful as they are, societies survive them. ... If ever there were a wake-up call for Western society to rethink its dependence on ever-accelerating technological innovation for ever-expanding fuel consumption, surely the BP oil spill should be it. ...
Economics teaches us that when there is huge uncertainty about catastrophic risks, it is dangerous to rely too much on the price mechanism to get incentives right. Unfortunately, economists know much less about how to adapt regulation over time to complex systems with constantly evolving risks, much less how to design regulatory resilient institutions. Until these problems are better understood, we may be doomed to a world of regulation that perpetually overshoots or undershoots its goals.
The finance industry already is warning that new regulation may overshoot – that is, have the unintended effect of sharply impeding growth. Now, we may soon face the same concerns over energy policy, and not just for oil. ...
The balance of technology, complexity, and regulation is without doubt one of the greatest challenges that the world must face in twenty-first century. We can ill afford to keep getting it wrong.

Just one comment. If the risks of too little regulation are very large -- catastrophic oil spills, financial crises, and the like -- much larger than the potential costs from too much regulation stifling innovative activity -- then there should be a bias toward erring on the side of too much rather than too little regulation. Thus, the fact that "new regulation may overshoot" is not worrisome, it is optimal, and it seems to be we could have used what would have appeared to be overshooting prior to the recent financial and oil spill crises.

In addition, suppose that regulation had prevented the recent meltdowns and accidents. We never would have known -- catastrophic events that don't occur are not observable -- and there would have been considerable pressure to ease the regulations that were in place. There would have been argument after argument about regulatory overshooting, and considerable pressure from the "loan, baby, loan" and "drill, baby, drill" crowds to ease off (see Obama opening up offshore areas to drilling). I can even imagine Rogoff writing a Project Syndicate piece making the argument that financial markets are unduly constrained. So I am not particularly persuaded by worries that we will overshoot. As I said, we could have used a little more of what would have been called overshooting prior to the recent crises.

    Posted by on Tuesday, June 1, 2010 at 10:53 AM in Economics, Environment, Financial System, Market Failure, Regulation | Permalink  Comments (29)


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