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A Fire Sale on the Apocalypse
Published on February 17, 2004 By Phil Osborn In Politics

When we find a product artificially undervalued, then we also expect to find a run on that product, and subsequent lines or ques. Recently at the local Orange County, California public libraries, for example, for about a year, printing from the internet computers was free. The Costa Mesa Technical branch, in particular, which features about 30 fast computers with LCD screens, also started out with a couple of very nice Kodak wax transfer hi-res color printers, which can provide a nearly magazine-cover glossy color print.

The consequence was predictable: some people took advantage. One night, a couple of ministers from different Christian sects battled over who would control the printers to print out their Church literature. Presumeably both called on divine assistance. Both ultimately left in disgust, with a week's worth of printing backed up, preventing any of us sinners from using the printers at all, as the software did not then allow the librarians to selectively cancel print jobs..

A lady used to come in every night, invariably asking for multiple extensions on her free one hour on the net, so that she could also jam the entire system with hundreds of full color prints of stock market charts. I tried to explain to her the simple process of cut and paste, by which she could have grabbed only the information she actually needed and then printed it by itself. To no avail...

Finally, the libraries instituted a charge of 15 cents per page of printing, and, lo and behold, suddenly everyone was able to print, and the lady stopped coming at all.

Virtually anything or any aspect of any thing which is of limited availability can fall prey to this problem. In Russia under the communists, there was a production problem for consumer goods.

But, the Russians could not admit that they couldn't outproduce the evil capitalist countries, so they set the prices low for basic items. As a consequence, there were long lines for virtually everything. Thus, that became part of the cost of the item, and ones position in line became a marketable commodity. Of course, a healthy black market was also a major feature of the Russian experience. You could avoid the lines if you paid the right bribe, in cash, sexual favors, or whatever you had to barter.

In perhaps the worst case example, the Russians boasted that they always had plenty of bread. And they did. They virtually gave it away at vastly subsidized prices, and the lines there were REALLY long, as people filled up wheelbarrows and wash tubs with bread to feed their pigs or chickens or brew kitchen vodka or burn in their fireplace or whatever.

The economist son of Nobel Prise Laurette Milton Freidman, David, once gave a talk on the subject of how econimists thought about things. One of his examples was the import fee structure of India. Typically, India would assess an import duty on manufactured goods equal to the cost, so everything cost double as a consequence. However, for special needs there were waivers of the import duty, available from your local bureacrat. Now guess how much the average waiver backsheesh was? How about just under the cost of the item? The savings from making a bribe were just enough to pay for the time lost by the average importer.

Now let's look at a market commodity called risk. Risk is a measure of the liklihood that an investment will fail, failure being defined on a spectrum from negative return on investment to lower than hoped for yield. Market analysts spend their lives on calculations of risk, and we all make decisions every moment of our lives in which risk is almost automatically factored in.

There is a real, but small, risk, for example, that we might have a major earthquake and our roof might collapse on us. But we still live under roofs that might kill us, altho some of us might be keeping in mind where the exits are and the table legs, in case we decide to duck and cover.

On the other end of the risk spectrum, salesmen deal constantly with the risk of not making a sale. In fact, for many salesmen, the risk of not selling is 90% or more per attempted sale. However, the 10% is sufficient to pay for the 90% waste.

What happens when you impose artificial limits on risk? For example, the power industry wanted to build nuclear power plants in the 1950's, but they couldn't get insurance. Why was that?

Well, the insurance companies are the experts on risk. They maintain endless actuarial tables showing what the expected risk for various ventures is, so that they can offer insurance rates that are high enough to cover the expected risk, but not so high that their competition will undercut them.

They told the power companies that they absolutely could not offer them insurance, without which the power plants could not be built. The reasoning of the insurance giants, who were the experts in assessing risk, remember, went along these lines:

We do not know what the risks associated with a nuclear power plant are. We do know that they could be disasterously high, involving massive loss of human life and permanent contamination of large urban areas. This risk might be very small, but if it comes due, it might be catastophic, utterly destroying the insurance company. No expert can convince us that the risks are exagerated, as we have no track record and we can't even accurately assess who would be a proper expert, so we simply cannot proceed responsibly.

Of course, they may have added (and almost certainly did), we would really LOVE to have your business; so, if you were to have a law passed specially for you, putting a cap on your liability by state fiat, then we can talk.

And they did. The law was passed putting an $800 million dollar cap per incident on the nuclear power plants. Now what do you suppose was the market result? The price of risk was artificially lowered, just like bread in Russia, or color printouts at the library. And the ques began to form, starting with the insurance companies, fighting for access to cheap risk.

The impact on the actual power plants is harder to measure. Risks with payoffs below $800 million would not be effected, of course. But, anything over $800 million was discounted. If you had two courses of behavior, each of which had a one in ten thousand chance of resulting in a loss greater than $800 million, which course would you adopt? Economically, the right answer is whichever is otherwise cheaper.

So, you figure that if the plant is blown up by terrorists, then the actual losses will be upwards of 100 Billion dollars. Maybe you could reduce that to 50 billion (meaning tens of thousands fewer deaths) by incorporating designs that specifically addressed that kind of catastrophic failure of containment. But, where is the profit? 50 billion or 100 billion, your loss stops at 800 million.

In terms of economic decision theory, a simplified model illustrates the issue: Assume you have a downside of $100 billlion for a particular set of threats, with a one in ten thousand chance of one of them actually happening. The expected cost, then, is $100,000,000,000 x .0001, or $10 million. On that basis, you can economically justify to your stockholders spending up to $10 million to eliminate that risk altogether.

Since that is unlikely, however - that you could entirely eliminate that risk, then you look at various types of expenditures that could be expected to reduce either the total cost of $100 billion, or the likelihood of 1/10,000. Before you spend the money, you have to show that the expected cost has been reduced. If, by spending $4 million, you can reduce the $100 billion to $50 billion, then, if there aren't any better options, that would be a justifiable expense, as your expected cost would have been reduced from $10 million to $5 million, for a net gain of $1 million. However, capping your total liability to $800 million, means that these calculations no longer make any sense. Why spend any money if the scenario is going to go over the cap regardless?

Eg., you might put in enhanced security that might be able to slow the terrorists down and at least get a warning out to the surrounding population a little quicker. And you might consider a warning system that would give people a chance to get out of harm's way. Or a bunch of robotic buldozers that could move right in like Chernoble, but without killing the operators. But, many of these options would be expensive, and they would not have much impact on a 799 million dollar accident, while they would cut tens of billions off a really big one. So, why bother?

And this, indeed is what we now know really and truly happened. Because after 911, we checked around and discovered that the nukes had abysmally lousy security, that ANY half-competent team of terrorists could penetrate. So, we ordered them to fix it, and that took care of it, right?

Not. It only required that they move on a limited set of options to satisfy the inspectors. There was still no incentive for the management to proactively move to reduce the really catastrophic risk. Given the cap on liability, how would they even begin to make the calculations? And money spent to decrease higher risks would mean less money available for risks below $800 million, so the management has every incentive to minimize those expenditures.

And it's doubtful that they in fact could do much anyway, at this point. They have incorporated the artificially low risk structure into every aspect of their design and function. Not because they are BAD people, but because they were handed a business situation and had to make the best of it or go out of business. (Let's not give any more of that store away... ok???)

Now consider the fact that the very incentive for the existence of the corporate business model is the artificial cap on risk. Ltd. "Limited Liability" by state fiat. And now we have literally millions of these artificial persons with caps on their liabilities. And they DO behave accordingly, even though most of them are perfectly fine people, just trying to run a business ... just like the nukes.

And I mean, multi-national trashing of the ecosystem, ENRON gaming the market, slave labor burgeoning in the 3rd world, while viable native farmers are being wiped out to support less efficient and ecologically destructive corporate farms. And that's just the tip of the iceberg created by artificially lowering the cost of risk. Just write off the really bad consequences or isolate them to a subsidiary like ENRON did.

Is it any wonder what a mess we're in? It's the kind of mess you get into when you start denying reality. Risk is a fact, like bread, and just as real. You don't legislate it away, any more than you can repeal the law of gravity. Risk IS. Who pays for it is another question.


Comments
on Feb 18, 2004
It was a little rambling. What is your point? And I ask because you seem to have a gem somewhere in here but I am digging, and re-reading, and can't find it.

Would you agree that risk can best be defined as: a probability that something undesirable might occur.

Assessment of the probability is tricky business - subject to human interpretation and incomplete or misleading facts.

Assessment of the cost should the outcome occur is similarly tricky business.

Some say given enough time, everything is "inevitable".
on Feb 18, 2004
His point is that risk affects the decisions we make. When liability is limited, we choose riskier behavior than we would otherwise have. Corporations have limited liability, in that their owners and employees are usually not held fully liable for the actions of the corporation.

For example, a manager decides to sell an unsafe product. Now consider what happens when this situation is discovered. With no limited liability, the manager goes to jail and the corporation pays a fine. If the corporation runs out of money, the owners must pay. With limited liability, the corporation pays out of corporate funds. If the corporate funds run out, the owners lose the corporation, but nothing more.

OK, I think that what he's saying can be accepted. However, I would say that it isn't black and white. The state does have an interest in reducing liablility so that people will do *something*.

If there was no limited liability, would you invest in a venture, knowing that if someone associated with the venture did something wrong, you could lose everything you have?

Consider the standard of living, including food, shelter and medical care, that the citizens of industrialized countries enjoy. How much of it would be possible if the limited liability corporation did not exist?

I think the question is: how much should liability be limited and who should be liable (I'm thinking of situations where an employee misbehaves without corporate consent).
on Feb 18, 2004
zxtt

Thanks for clarifying the issues for PoetPhilosopher.

However, you are incorrect in assuming that alternatives to the corporation do not exist. Prior to the large scale move to corporations, other business structures dominated, such as "trusts." Trusts limited liability to the "trustees," as the shareholders had no direct control over the actions of the Trust. Thus, while anyone can be sued for anything at any time, successful lawsuits against shareholders in trusts for the actions of the trust never happened to the best of my knowledge.

A Trust is a purely private contract between trustees and shareholders, owing nothing legally to the state, unlike a corporation, which can only exist as a creation of state fiat.

The so-called "Trust-Busting" era of the later 19th and early 20th centuries was not actually aimed at destroying big business, nor at reducing its power or capacity for mischief, although those kind of arguments were widely publicized then and now. The purpose was specifically to force all business into the corporate mold.

Why? Because the very people financing the "progressives" who were spearheading the "trust busting," were, in fact, the very moneybags who owned the majority shares of the largest trusts. They concerned, for slightly different reasons, with the then "progressive" vision of an empire state with industry and government marching side by side and taking over the rest of the world for America's glory, and, of course, to spread our enlightenment to the savages... (Sound familiar?)

The money people knew very well who would control the puppets in Congress and the Senate, and thus who would dictate who would be appointed to the various regulatory boards and bureaucracies. Corporatization, for the people at the top, did not mean losing anything, but rather locking in their market positions, by making effective competition impossible. Meanwhile, they were shielded from major lawsuits over issues such as pollution by the fact that the regulartory apparatus had jurisdiction. Thus, the courts would typically throw such suits out. AND, they got limited liability. What a deal! For them, not for us.

Check out (http://www.gangsofamerica.com/) Gangs of America, for a really excellent history of corporations and how they have looted the country in the name of free enterprise - which they are not.

Meanwhile, I expect to add to this article, especially showing how the move to corporatization was enabled and fueled by the corruption of the common law court system. Stay tuned.
on Feb 18, 2004
ehh.. I'm not convinced - there is nothing "natural" to the notion that businesses should have unlimited liability. Reply #2 astutely points out that there is a benefit gained (thru innovation, etc) by limiting at least the high end of the loss curve (catestrophic).

Should liability be zero - no
Should liability be unlimited - no

The balance lies somewhere in between I think.

I shall return as you post more. Good info - if a bit difficult to read (maybe it's me).
on Feb 19, 2004
The problem, upon which I will be expanding soon, is that the courts were corrupted. Under the strict Common Law, there is no criminal law and no punitive judgements. Either of those would require the court to act as an agent for some particular brand of public morals. The Common Law is strictly about equity, i.e., restorative justice, setting things right again...

However, we have never had a pure Common Law in this country, nor, since the Norman invasion, in England, altho the mythical Goode and Ancient Common Law of merry Anglo Saxon England was in truth pretty primitive. Ireland, however, is generally reported to have developed a very sophisticated Common Law, prior to the British invasion.

So, the conquerors always need to put a lid on the Common Law by imposing a set of Roman style positive laws on top of it. Otherwise, the Angles and Saxons could have sued them for invading - and won! This bastardized Common Law is essential for conquerors, and opens the door for every future perversion of justice.

Thus, as punitive damages became popular in the 19th Century U.S.A., businesses of all sizes were put in jeapardy of losing everything. Trusts could limit liability to the Trustees, but other business forms, such as partnerships, were open season for crooked attorneys. Insurance rates naturally skyrocketed. This created the demand for a solution, and the solution being pushed in everyone's face was the corporation.

A better solution would have been to reform the courts and return to a strict version of the Common Law, but too many people had vested interests in positive law privileges. So, there we are, and the bill is coming due.