18 Nov The World is Too Big to Fail But…
Who is Going to Bail it Out?
By Anjum Altaf
We have all read the stories about very big entities failing and being bailed out – these include cities like New York, countries like Mexico and Pakistan, and corporations like General Motors and Bank of America whose businesses were bigger than the economies of many countries. All of them defaulted on their debts – went bankrupt – and were bailed out by an entity that was bigger than them, the US Government alone or in concert with other developed countries.
The combination of size and of the existence of a savior, the protector of last resort, gives rise to a dilemma that is known as ‘moral hazard.’ When an entity believes its failure would damage the rest of the system and that there is someone who will not allow that to happen, then it loses the incentive to manage its risks prudently.
This is quite easy to imagine. If the corner bakery fails no one would bother about it – this is considered the strength of the free market which promotes efficient competition by weeding out incompetent firms. But when General Motors fails, this logic is suspended because GM’s failures could trigger cascading failures throughout the auto industry and its service economy. Because the managers of General Motors believe this, the incentives that guide their behavior and that of the owner of the corner bakery are quite different. For example, GM managers can take outsized risks and give themselves big bonuses even when the company is making huge losses. Similarly, Pakistan’s leaders can mismanage and pillage the economy knowing American policymakers have determined that Pakistan cannot be allowed to fail – which is great for the leaders but terrible for the citizens.
This brings us to a consideration of the world in the context of the global climate crisis. What can be bigger than the world? But, if the world fails, who will bail it out? Allah maalik hai is all and well but even if we fall back on that divine cushion we should remember the corollary that God helps those who help themselves. So, how exactly are we going to help ourselves in this crisis?
Let us leave aside for the moment two contentious issues: Is this crisis for real and, if so, is it the doing of human beings? My interest is more in figuring out how one goes about thinking of such an issue – so let us assume that it is real for the sake of argument. (The Government of Maldives already does and is looking to buy land in anticipation of a rise in sea level that would submerge the islands. South Asia is projected to be amongst the most affected regions by global warming.)
I find useful an analogy similar to the comparison between General Motors and the corner bakery in the context of moral hazard. Think of two households; however, instead of size, now focus attention on the differences in the nature of household budgets. Suppose the monthly household budget is Rs. 20,000 that you get in cash at the beginning of the month. In one case, you know that if in a particular month you break the budget (expenditures exceed allocations), you can borrow the balance from a bank or be subsidized by your father. In the other case, if you go over budget, your house is repossessed – it’s the end of the game. The first is known as the ‘soft’ budget constraint; the second as the ‘hard’ budget constraint. As you can imagine, the softness or hardness of the household (or business) budget constraint has a great impact on individual behavior.
Now apply this analogy to the environment. Clearly, our behavior reveals that we have been living in a world where we feel we are governed by a soft environmental constraint – we believe we can borrow against the future, i.e., we can have economic growth now and have the luxury of cleaning up its environmental consequences later. At the present time, the starkest example of this is China which is fueling its rapid economic growth by building more than one coal-fired energy plant a week. As a result, seven or eight of the ten most polluted large cities in the world are in China with some known and many unknown health impacts on the residents.
Presumably, China believes that it can follow the path trod by the West. Western cities were environmental hell-holes well past the Industrial Revolution but most were successfully cleaned up later – the London and LA smog are still remembered by many people (the former so well described by Eliot in The Love Song of J. Alfred Prufrock). The scenario in India is very similar to that in China, only less intense, which is not for any lack of trying by the Indians – inefficiency can at times be good for you.
But what if the environmental constraint is no longer soft? What if the decades of abuse of the environment (at least since the discovery of oil-based energy) have now turned it into a hard constraint? What, if that last unit of carbon dioxide emission that would trigger an unstoppable runaway process is close at hand? What if we have arrived at the tipping point beyond which all the king’s horses and all the king’s men would not be able to put Humpty Dumpty together again?
This is what an increasing number of scientists are warning – we are close to such a tipping point. And this opens up a host of interesting issues. Climate change does not know any borders – in the end it will not matter whether the bulk of the damage was done in the past by the now developed countries. The innocence of the developing countries will not save them – as mentioned before South Asia would be one of the most affected regions from sea rise at one end to glacier melt at the other.
So, how are developed and developing countries going to find a mutually acceptable agreement that is both fair and goes far enough to make a difference? What kind of rules and morality applies in situations like these where the whole system is at risk and there is no one to bail it out. I can’t help my mind going back to the partition of the Indian subcontinent – its leaders kept bickering and were unable to find an acceptable agreement leading to a million deaths and ten million homeless. Is human shortsightedness, false pride, sheer stupidity, and lack of feeling for ordinary people going to make us witness a replay only now on a global scale? This time there might be no one left to gloat over the superiority of one side over the other.
It is useful to end with what has been termed the ‘boiling frog’ analogy: if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death.
Will we allow ourselves to be cooked to death? Is it hubris to think humans are any wiser than frogs?
For the implications of climate change in South Asia see the special Autumn (October-November 2009) issue of Himal Magazine. For an argument that we have left it too late see this interview. For an essay competition on the tipping point, that fateful last tonne of carbon dioxide, see The Ecologist.