09/10/2008 05:12 am ET | Updated May 25, 2011

The Price of Risk

Seems to me when you get right down to it, a lot of what's gone wrong in the economy, if not the country, stems from the failure of the market to accurately price risk. It sounds obscure, but if we don't get this right, we're looking at a shampoo economy -- bubble, bust, repeat -- for years to come. Not to mention environmental degradation and war.

What is 'the price of risk,' how did it get too cheap, and why is this such a problem? After all, cheap's good, right? Read on.

Buying insurance is a good way to think about these problems. When you purchase insurance, you pay a premium to insure you against some risk, whether it's getting sick or your house burning down. For the system to work, the price of the insurance must reflect both the likelihood that the event will occur and the cost of its occurrence.

If the premium is too low given these criteria, you don't have enough of an incentive to try to diminish the risk. Why be careful, when the cost of being careless is minimal?

Now think about the world of finance. Suppose you're lending me the money to buy a home. Presumably, you're pretty interested in my ability to pay you back, so you engage in some careful 'underwriting' -- learning as much as you can about my creditworthiness. If you think I'm a bad risk, no loan for me. If you think I'm probably okay, but you're a little nervous about that $1,000 I owe to Tony Soprano, you'll raise the rate of interest on the mortgage loan.

In other words, any signals that that the risk of repayment may be higher than you -- the lender -- like, should translate into a higher price of risk, in this case through the terms of the mortgage (higher down payment, higher interest rate).

Of course, false signals can raise the opposite problem. If a discriminatory lender believes that people from neighborhood X are credit risks, she will raise the price of borrowing too high and unfairly block creditworthy X-dwellers from opportunities they need and deserve. That's illegal, but it happens all the time.

That's an old problem. Our new problem is that risk has been under-priced, leading all kinds of people to get in over their heads. I'm not saying such people are blameless. But it's human nature to trust the price system, including the part that prices risk. Those folks who shouldn't have taken on sub-prime, no-doc, low-loc, NINJA (no income, job, or assets) loans, believed lenders who said they could afford them.

And they could have, if their home prices kept defying gravity, which any sensible risk-assessor could have told them wasn't going to happen. But that was only one thing that jammed the risk-pricing signal.

Another was the fact that lenders increased their distance from borrowers. You'd also be a lot less prone to worry about my ability to service my loan if you could turn around and sell that debt to someone else. Of course, that 'someone else' might still worry about the health of the loan, but if the bad one is chopped up, mixed in, and sold with good ones -- which is exactly what happened with so-called mortgage-backed securities -- debt holders down the line couldn't price risk accurately either.

So far, we've identified two suspects in the mystery of why risk was under-priced: financial "innovation" and bubble mentality.

But there's much more. The recent case of Fannie Mae and Freddie Mac shows what happens when institutions have the implicit backing of the government (that's us, btw), i.e., they're too big to fail. In this case, the good folks at Fan and Fred will under-price the risks in the loans they're taking on because they know that if the loans fail, the taxpayer will step in and make up the difference. So, why worry? Bear Stearns, too.

Why is this a problem? Well, there are millions of people who are now losing their homes who would be happy to answer that question for you, but as I've written in this space before, bubbles, born of under-priced risk, are terribly damaging, much more so than economists typically admit. The last two recessions were brought to us through bursting bubbles (housing, today; IT in 2001; some would add banking in the 1990-91 downturn), and self-inflicted recessions are really something we want to avoid.

That's all pretty obvious stuff, at least with hindsight (you want to go deeper into the mortgage meltdown, read Mark Zandi's crystal clear explanation in his new book, the royalties of which go to an investment fund for disadvantage areas--you go, Mark!). But once you start worrying about this problem of inadequate risk-pricing you see it in a lot of scary places.

The most important is also the least well-recognized: the environment. Obviously, it's widely known that we've got an existential challenge on our hands, but it's too rarely tied to under-pricing the risk of environmental degradation. Because our risk horizons are short, and we're very price sensitive in this country -- the whole damn election seems to be reduced to the price of a tank of gas--the real price of much of our economic activity fails to reflect the damage to the planet. This isn't surprising, because the damage is now most evident in faraway places (see Artic Circle) or down the road a number of years. But if prices truly reflected the present value of these future "costs" -- if the prices were accurate from the perspective of environmental risk -- a lot of stuff would cost a lot more than it does.

Gas at the pump provides a timely example. Economic realities, leavened with some speculation, are pushing up the price and sending us a signal to do the right thing: conserve and look for alternatives. From my perspective (and from Al Gore's too, I'd say), the current price of fossil fuels is more in line with the risks that using evermore of it poses to our environment. And what are we doing? Begging the oil companies to quickly poke more holes in the ground and lambasting the politicians who have the spine to stand up against this knee-jerk reaction. We want our risk under-priced and we want it now!

Please don't get me wrong. Much of my economics career has been devoted to analyzing the squeeze on middle- and low-income families, and I absolutely recognize the conflict between higher prices on goods which comprise a disproportionate share of their budgets and the need for these goods to accurately reflect the risks they engender. That's why we need progressive solutions, such as taxes on carbon with rebates to those with lower incomes, and aggressive pursuit of alternatives.

A word on politics and then I'll stop. Obama gets all of the above (full disclosure: I'm an informal advisor to the campaign). I know he's adjusted his position on drilling, but he's got to be pragmatic right now. If he fails to get elected, we won't have any chance of correcting the epidemic of risk under-pricing, whether it's in financial markets or energy. Especially on the latter, and even more especially compared to McCain, he plots a regime-changing path that we can't afford not to take.

Remember, "conservative" used to mean risk-averse. Now it means "risk be damned, I want my oil, my house, my risky financial instruments, and my government bailout when they fail." You can even see where they under-priced the risk of their war in Iraq, with that nonsense of how we'd be embraced as liberators.

Enough, already. We've got a chance to show these greedy, short-sighted, risk mongers the door. Let's be sure to take advantage of it.