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The Straits Times (Singapore) April 14, 2009 Tuesday

Public input vital in decision-making process

BYLINE: Alex Tham SECTION: REVIEW - OTHERS LENGTH: 1108 words

ALMOST 90 years ago, the economist Frank Knight distinguished between risk and uncertainty. Risk, according to him, could be assigned a probable value, whereas the cost of uncertainty was essentially unknowable. The proliferation of sub-prime mortgages, collateralised debt obligations and credit default swaps was largely due to the assumption that the risks they carried were measurable with the aid of mathematical models. But while these models might have been able to quantify the value-at-risk, given a certain time horizon, they were unable to account for the extreme possibility of a crisis occurring. Nassim Taleb, author of The Black Swan, warned that these disastrous outliers occurred with far more frequency than we assumed. Instead of managing risk for profit, financial firms were in effect gambling with uncertainty. The recovery of the global economy now hinges on our replacing uncertainty with manageable risk. In a dynamic and competitive environment, uncertainty over future profits can threaten to overwhelm prudent risk management. Deregulation of the financial sector created a Hobbesian world where self-seeking firms fought among themselves for the spoils of capital. Corporations like Citigroup became megalithic entities and generated competitive pressures for other firms to grow bigger as well. Risk management was consigned to the sidelines. The numbers that mathematical models churned out took on the aura of oracles. Senior management made decisions based on the output of these black boxes without due consideration of their limitations. In doing so, they neglected the fact that risk management also involved qualitative judgment. To redress the balance between risk and uncertainty, governments have actively intervened in markets and will play a bigger role in regulating them. This is in line with what Thomas Hobbes wrote in The Leviathan, where he prescribed a common power to keep men obedient and 'direct their actions to the common benefit'. However, people will find creative ways to circumvent restrictive rules in their quest for profit. Worse still, outmoded regulation could hinder innovation and productivity. Moreover, it should not be taken for granted that governments are best placed to determine what constitutes the 'common benefit'. In the United States, the Glass-Steagall Act that separated commercial from investment banking was repealed in 1999 during the Clinton administration. Ironically, one of the arguments in favour of its repeal was that it would facilitate the diversification of risk through securitisation. Instead, uncertainty was transferred to the public whose insurance, pensions and life savings were invested in toxic assets like mortgage-backed securities. In 2004, the US Securities and Exchange Commission removed the net capital requirement for several major banks,

Page 2 Public input vital in decision-making process The Straits Times (Singapore) April 14, 2009 Tuesday

enabling firms like Lehman Brothers to take on dangerous levels of debt. Among those lobbying for the removal of this requirement was Mr Hank Paulson, then CEO of Goldman Sachs. As US Treasury Secretary last year, he pushed for government bailout of financial firms. So far, the US government has failed to replace uncertainty with measurable risk. As a result, credit remains tight. Current Treasury Secretary Timothy Geithner recently unveiled a new plan where the government would finance the private sector to bid for and purchase toxic assets from financial institutions. One of the aims of the plan is to dispel uncertainty over creditworthiness and free up capital. But the mechanism to do so benefits private investors at the expense of the public. As economist Jeffrey Sachs of Columbia University pointed out, if the toxic assets are worth even less than the non-recourse loans provided to the private sector by the US government, then taxpayers will shoulder the burden of the loss. Heads, the private sector wins; tails, the taxpayer loses. The problem is that governments, like corporations, make decisions based on the information they have at hand and are blind to the unintended consequences of their actions. Senior management in financial companies took big bets based on what their mathematical models told them - and did so because they presumed the models would tell them all that they needed to know about the risks involved. Many also wrongly assumed that they could sufficiently gauge a company's creditworthiness based solely on its credit rating. Such resources were relied upon because they were institutionally available and there was little incentive not to rely on them exclusively. Likewise, government policy is formulated in agencies whose corridors are traversed mostly by technocrats, bureaucrats and corporate insiders. It is not unlikely that government policy is also based on, and therefore limited by, the information and incentives distributed among a small group. In organisational theory, there is a school of thought that views decision- making as an almost random process: Individuals who do not have complete knowledge come up with solutions based on the available information they are currently able to access. The lack of alternative information explains why problems can perpetuate. People tend not to think out of the box. The masses are just as guilty of information bias. They follow the herd and get carried away by apparently irrational 'animal spirits'. Yet this is a reasonable course of action, given the available information at any one point in time. In this sense, rationality - or the reasoning behind decisions - is 'bounded'. If we accept that individual and organisational decision-making is based on bounded rationality, then we would realise that uncertainty can be overcome by expanding access to information. The assumption here is that bureaucratic complacency, corporate greed and the ignorance of the masses can be overcome if knowledge is openly shared and risks are prudently assessed. This kind of radical transparency goes beyond accountability because externalities are addressed before, not after, decisions are made. The Internet is a space where decision-making processes can be evaluated, critiqued and improved upon by the public. But individual blogs and forums are not enough. There should be a common standard enabling the public to freely contribute to knowledge accumulation that also incentivises responsible and constructive inputs. Most importantly, public input must be taken seriously. The writer is a research associate at the Institute of Southeast Asian Studies. If we accept that individual and organisational decision-making is based on bounded rationality, then uncertainty can be overcome by expanding access to information. LOAD-DATE: April 13, 2009 LANGUAGE: ENGLISH

Page 3 Public input vital in decision-making process The Straits Times (Singapore) April 14, 2009 Tuesday

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