Five books on unexpected economics

Tim Harford is the author of The Undercover Economist and The Logic of Life.

His new book is Adapt: Why Success Always Starts with Failure.

At The Browser, he discussed with Sophie Roell five unexpected economics books, including:

Normal Accidents
by Charles Perrow

[Y]our first choice is seemingly not about economics at all. It’s called Normal Accidents and is by Charles Perrow. He is, I believe, an expert on the safety of systems and, in this book, argues that as technology gets more complex, the odds of tragic accidents occurring are increasing.

Yes. Charles Perrow is still going strong: I think he is now in his eighties. He is a sociologist, but got very interested in unintended consequences, and from looking at those, got very interested in technological disasters. For him, at the time he published the first edition of this book, Three Mile Island [the nuclear core meltdown in Pennsylvania in 1979] was the definitive one. It prefigured Chernobyl. And then he revisits the subject at the end of the 1990s. The book goes through awful accidents in complex systems and explores why they happened – the human failings that go into them, the systemic consequences, the fact you could have a very small error that propagates and propagates. It’s quite a technical book, but it’s wonderful and completely compelling.

I originally read the book because I wanted to write about a particular accident. My sister is a qualified safety engineer, and she gave me a bunch of safety engineering books. But as I read Perrow’s book, I realised that it could have been written about the financial crisis. That was really shocking to me – this realisation that these banks and their interconnections were, in many ways, the same kind of system as a nuclear reactor, or at least had very important similarities.

And is there any way of avoiding this kind of disaster in future? Does the book shed any light on that?

Perrow is, in many ways, a pessimist. He says that if the system is too complicated, you will have accidents. There’s nothing you can do about it. Looking back at the history of financial crises, that’s probably appropriate. But one thing that comes out of the book is the idea that we tend to make systems more complex by adding safety systems on top of them, and that the safety systems themselves create new ways for things to go wrong. That was a key problem in the financial crisis. A lot of banks were taking bets and then insuring themselves with credit default swaps (CDS). Credit default swaps were, basically, insurance contracts that banks wrote, often with [the big insurance company] AIG. Or banks were repackaging sub-prime mortgages into vehicles that were supposed to make risky loans safe. These two innovations – the packages of sub-prime loans and the credit default swaps – were both safety systems. But they were both absolutely crucial in explaining why the system blew up. I think that’s a central and really useful idea, that these safety systems are probably not helpful – and even when they are helpful, they will have unintended consequences.

Is that because they lull us into a false sense of security?

That is one of the things they do. In the case of credit default swaps, they were specifically designed to allow banks to take more risks, with the approval of regulators. The entire point was to allow more risks to be taken. So yes, absolutely, that is part of the problem. But also, just by virtue of making the system more complex, they introduce new ways for things to go wrong. That was very much the case with Three Mile Island. Three Mile Island was a nuclear accident triggered by a safety system. In the case of the financial crisis, credit default swaps introduced unexpected links in the financial system. You have small banks with what appear to be perfectly safe packages of loans, insured with credit default swaps. But those insurance contracts turned out to be links to risks elsewhere in the system.

It’s a bit like climbing a mountain. You’re roped together, and you think the rope is making you all safer. Then, suddenly, a couple of people fall off. You realise that it’s the rope that’s dragging you all off the cliff – even people who were never in trouble themselves.

Read about the other books Harford tagged.

Visit Tim Harford's website.

Tim Harford: top 10 undercover economics books.

The Page 69 Test: The Undercover Economist.

The Page 69 Test:The Logic of Life.

The Page 99 Test: Adapt: Why Success Always Starts with Failure.

--Marshal Zeringue