The most gripping and scary takeaway from two new books on the recent financial meltdown’s origins, Scott Patterson’s The Quants and Michael Lewis’ The Big Short, is that while the financial instruments whose use led to the crisis (collateralized debt obligations and credit default swaps) baffled regulators, bond raters, and even many bond traders, the reason for trading them was simplicity itself. Those who bought CDOs and those who sold CDSs believed that home prices would never go down. The probability of catastrophe—massive numbers of mortgage defaults as home prices fell—was considered vanishingly small, and the defining narrative of the period became “rare events can’t happen.” Wall Street and the millions of Americans who took on outsized mortgages bought into this philosophy even though the dot com bubble, the current gold bubble, and the tulip bubble have all been just such products of totally ungrounded optimism.
As a researcher on crime and justice policy, I’m struck that this optimism runs completely counter to how we think about crime, and, by extension, terrorism. Take homicide. In 2009, there were 15 thousand homicides in America; that is, about 1 in 20,000 Americans were murdered. That number includes many murders that are almost immune to public precautions (infanticide, domestic violence) and others that are extremely hard to prevent but affect a relatively small number of Americans (youth killing peers). Only about 1 in 100,000 Americans was murdered by a stranger, roughly the same rate as death by drowning. So, ‘homicide’ as we commonly think of it is an exceedingly rare event.
Now, while the financial markets took virtually no precaution against one rare event (widespread mortgage default), as a society we make huge investments to prevent the other (homicide). While one is life and death and the other is not, the size of the bets were roughly equivalent—the US spends roughly half a trillion dollars a year on police, courts, jails and prisons, and the markets gambled away a trillion or more over a few years. Of course, not all anti-crime spending is on homicide prevention, but it definitely dominates the use of law enforcement resources—from investigating a homicide crime scene, to trying a murder case, to incarcerating (or even executing) offenders.
We treat terrorism much the same as homicide. As RAND’s Gregory Treverton aptly puts it, “Anyone’s probability of being killed by a terrorist today [i]s essentially zero and would be tomorrow, barring a major discontinuity. So, they [the public] should do nothing.” Obviously, government must respond, but the sums spent on anti-terrorism—from Homeland Security to intelligence gathering— reflect deep concern over an event far rarer than others that result in more deaths.
The incongruity is startling. One set of revealed preferences, as the economists would say, of our collective willingness to pay to avoid a rare event suggests wild-eyed optimism (the mortgage market can’t collapse) while the other suggests near-panic levels of pessimism (homicide prevention, terrorism). Why spend wildly to prevent one type of terrible event (homicide) and utterly ignore another (market collapse, loss of your home)?
Behavioral economics may tell us why, at least vis-a-vis homicide prevention spending. Prospect theory suggests that individuals find losses far more painful than gains are rewarding. And a closely related theory, status quo bias, says that people won’t revise their beliefs until the incentives to believe something changes. As a result, Americans beliefs about crime are relatively unchanged, no matter that crime rates have been dropping for more than two decades. The media deserves some blame here since crime stories trump most everything else, and true crime shows like American Gangster draw their grist from decades old news. Meanwhile, government uses fear of crime to justify crime-fighting budgets. Perhaps the reason people are so fearful of crime is because they pay so much for protection. Since government is disinterested in spreading the good news about the crime decline, perhaps the financial crisis and need to cut expenditures create new incentives for people to view crime risks more accurately.
No theory, however, explains why bursting market bubbles don’t make people see that there is no market that can only go up. So watch out gold investors!