If it’s true that each of us has a “risk thermostat,” then some types of safety regulation might make us less safe than we think. Hypothesized by a psychologist at Queen’s University in Ontario, our “risk thermostat” is set at the level of risk we are willing to tolerate. Consequently, when risk goes down because of better brakes, football helmets, or loan guarantees, some of us have the incentive to behave more dangerously.
The antilock brake story, told by Greg Ip in FoolProof, displays perfectly how something that makes us safer can have unintended consequences.
Antilock Brakes and Safety Regulation
The Lincoln Continental Mark III was one of the first cars with antilock brakes. Produced in 1970, the new brakes were called anti lock because all other brakes at the time sometimes locked on slippery surfaces or when a driver pressed too hard for too long. Antilock brakes instead create a pulsing response to the driver’s pressure that stops the wheels from freezing. The result is safer stopping.
But that also was the problem.
Knowing they could stop more safely, some drivers drove more recklessly. The reason was their “risk thermostat.” Statistically, the numbers for crashes had not diminished. Yes, the crashes were different but they still continued. One study indicated that people with ABS (antilock braking systems) drove faster and then hit the brakes harder. Some had more rear end collisions. Others rolled off the road more. One researcher who looked at police records found that drivers with ABS had 60 percent more speed related offenses than non speed violations.
Similarly, the helmets that were supposed to make athletes safer seem to be increasing the number of concussions.
Antilock Brakes and Banking Regulation
Imagine for a moment that you are the CEO of a large bank. Offered the opportunity to participate in a risky business deal, you say, “Yes.” If the venture succeeds, you benefit. If it fails and threatens your bank’s survival, the government is there to experience the loss because your bank is “too big to fail.”
In a 2009 econtalk podcast, Gary Stern, past head of the Minneapolis Fed said that “too big to fail” distorts markets. Explaining why, he said that once creditors expect that an institution will be rescued, no matter how risky its behavior, its securities become mis-priced. With borrowing less expensive, bankers have the incentive to engage in the risky behavior that creates systemic calamity. As though they are driving with ABS, they have re-calibrated their “risk thermostat.”
Our Bottom Line: The Peltzman Effect
Sam Peltzman was one of the first economists to suggest that a solving a safety problem could create the results you are trying to prevent. While his seatbelt example has been proven inaccurate, his principle lives onward. When Greece joined the eurozone, the financial community assumed their loans would be safer so they bought even more Greek securities. When subprime mortgage packages got AAA ratings, people bought more of them. And when bankers think they are safer, their risky behavior can accelerate.