Prufrockian Political Economy

by Russ Roberts on July 22, 2010

in Curious Task, Regulation, Risk and Safety

When I talk about risk and safety, I always like to point out that it’s easy to make sure that no one ever dies in an airplane crash: ban air travel. The fact that we don’t suggests that we really don’t want perfectly safe air travel.

Similarly, it’s easy to make sure that you luggage is never lost when you fly–fine airlines $1,000,000 for every lost bag. (First heard this example used by Jonathan Skinner) Not only would you never lose a bag, if you could collect the fine as compensation, you’d encourage travelers to try to get their bags lost. But even without that perverse result, travelers don’t want a million dollar fine. True, no bag would ever get lost, but the cost of a ticket would become much higher because of all the costs that airlines would incur to avoid lost bags. The bottom line is that we don’t want the probability of a bag being lost to be zero.

Similarly, we don’t want ratings agencies to be perfect seers. The WSJ reports:

Ford Motor Co.’s financing arm pulled plans to issue new debt, the first casualty of a bond market thrown into turmoil by the financial overhaul signed into law Wednesday.

Market participants said the auto maker pulled a recent deal, backed by packages of auto loans, because it was unable to use credit ratings in its offering documents, a legal requirement for such sales. The company declined to comment.

The nation’s dominant ratings firms have in recent days refused to allow their ratings to be used in bond registration statements. The firms, including Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, fear they will be exposed to new liability created by the Dodd-Frank law.

The law says that the ratings firms can be held legally liable for the quality of their ratings. In response, the firms yanked their consent to use the ratings, hoping for a reprieve from the Securities and Exchange Commission or Congress. The trouble is that asset-backed bonds are required by law to include ratings in official documents.

The result has been a shutdown of the market for asset-backed securities, a $1.4 trillion market that only recently clawed its way back to health after being nearly shuttered by the financial crisis.

Many horrific results of legislation are intended. But this one, I suspect is more in the J. Alfred Prufrock category: That is not what I meant at all. That is not it, at all.”

As Hayek said in The Fatal Conceit:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

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