New York Times financial columnist Floyd Norris compares the global financial crisis to the Japanese nuclear accident. Mr. Norris found that “overconfidence born of experience led to increased risks once a disaster unfolded.” Japan’s Meltdown and the Global Economy’s
- The Financial Crisis – “In the world of finance, there was a general acceptance of the idea that banks and their regulators had developed sophisticated risk models to prevent a disaster. As lending grew more reckless, there was confidence that no real risks were being taken. “…In the world of finance, the assumption that safeguards would prevent disaster led people to believe it was safe to borrow heavily. There had, after all, been a prolonged period in which markets were not turbulent and there were only profits, not losses, to be realized from taking on the additional risk of leverage.” Japan’s Meltdown and the Global Economy’s
- Japan - “[T]he risks of earthquake and tsunami were well known, and believed to have been dealt with. An earthquake could damage a nuclear plant and its vital cooling process if power to the reactor were cut off. So backup generators were built and batteries installed to provide power even if the generator did not immediately kick in. A tsunami could cause flooding. So huge sea walls were built to prevent floods.” Japan’s Meltdown and the Global Economy’s
- All the precautions had worked in previous earthquakes, a reassuring history.
Unfortunately, the nuclear plant builders assumed that tsunami risk had been eliminated by the precautions of others. Backup generators were behind the flood walls, but were not on high ground. The generators flooded and the cooling systems broke down, with consequent radiation release. Whether this situation will lead to something much worse is still not known.
Mr. Norris then sprinkles journalistic “fairy dust:”
“Fortunately, there is reason to hope that the worst fears will not be realized. When — let us hope it is not ”if” — the radiation releases are controlled, Japan can begin to rebuild and the worst economic fears could prove to be as exaggerated as the depression fears that paralyzed financial markets two years ago.” Japan’s Meltdown and the Global Economy’s
“Hope” is not analysis. Mr. Norris misses the big culprit of these tragedies; i.e., that we live in an over financialized world with weak regulation. We have decreased society’s margin of safety, in the former case financial, in the latter nuclear.
Taking Risks
Years ago, prior to commencing bargaining negotiations, manufacturers would routinely hold extra inventory, for two reasons. One, this strategy warned the unions that they were serious about their position and willing to endure a strike. Two, during any strike customer deliveries (and hopefully loyalty) would continue. Many times I recommended such an inventory increase. As time progressed, management replied that the finance organization would not allow it: “too costly.” Here was an early warning that finance would come to dominate many business decisions, and not to the company’s long-term benefit.
Financialized behavior became so prevalent that corporate financial executives viewed the cash flow from real operations as fodder for financial engineering schemes: company owned life insurance, leveraged ESOPs, share buy backs and others. While these schemes are harmless enough (except for their effect on the US Treasury), they have more dire consequences when it comes to nuclear reactor design.
A Japanese engineer, Mitsuhiko Tanaka, worked on Fukushima Dai-Ichi No. 4, one of the array of six reactors. At the time of the March 11 earthquake and tsunami, No.4 was closed for maintenance. Mr. Tanaka confessed that:
- The reactor pressure vessel inside Fukushima’s unit No. 4 was damaged at a Babcock-Hitachi foundry in Kure City, in Hiroshima prefecture, during the last step of its manufacturing process. If the mistake had been discovered, the foundry might have been bankrupted. There was no disclosure.
- During the last phase of heat and pressure testing a reactor vessel wall warped. Proper procedure should have been to scrap it.
- The engineer was ordered to reshape the reactor vessel to hide the damage.
- The company saved billions of yen and the engineer received a sizeable bonus.
See Fukushima Engineer Says He Helped Cover Up Flaw at Dai-Ichi Reactor No. 4 (BLOOMBERG)
Dangers of an Over-Financialized World
Why are we surprised when multi-billion dollar, high profile, long-term projects like nuclear reactor construction have management and finance executives who try to cut every expense?
Consequently, the aftermath of the Japanese earthquake demonstrates the direct and indirect dangers of this over financialized world:
- Lack of backup power supply – The backup power supply for the Fukushima reactors was placed in the flood area near the reactor and failed after the tsunami. At greater expense the backups could have been placed on elevated ground away from the reactor. See Chinese Nuke Plant Safer than Fukushima
- Manufacturing components supply interruption – Since US manufacturing has shriveled we have become mere assemblers of goods. We rely on international supply chains thousands of miles long. It probably sounded like a great idea to the CFOs of the world, but we now face supply disruptions from Japan for key auto and electronic components. Concepts of a margin of safety, second source domestic suppliers or stockpiling are anathema to maximizing financial returns. See Global High-Tech Supply Chain Shaken by Japan Crisis
- Energy supply disruption – Electric supply in Japan is approaching critically low levels. There will either be plant closings or rolling blackouts which cut consumer electric power. This is due to years of underinvestment in conventional power plants. See Japan Electricity Losses: Summer with Air Conditioning???
- Foolish recommendations to buy Japanese stocks – Investment banking firms say that the crisis is overstated, the Japanese are a resourceful, determined people, and the selloff in the Japanese stock market is overdone. Inexplicably, they predict only a minor impact on global growth. See, e.g., Goldman’s Magnum Opus on the Economic Impact from Japan’s Earthquake. I would suggest financial speculation is the last thing we should be involved in. Has Wall Street turned every crisis into a stock buying opportunity, foolish or not?
Regulation
It is too soon to determine whether or not there was devastating nuclear regulatory failure in Japan. The Bloomberg article on the Fukushima nuclear engineering cover up highlights some frightening probabilities on this issue.
Whether in finance or nuclear regulation, watchdogs have been too willing to let industry have their way. As a legal advocate, many times I made the case to regulators that they were not considering the industry viewpoint. With the laissez-faire regulatory environments fostered by Greenspan and the Bush Administration, the message to regulatory employees was clear: “the less government regulation and interference in the free market place the better.” Industry can always make a statistical case that the chance of a financial or safety catastrophe is extremely low. But in these cases, industry profits trumped overall societal welfare. Disinterested, intelligent regulators free of political and industry pressure should have been centurions guarding the public welfare.
With issues like financial speculation, leverage and fraudulent mortgages, derivatives, mortgage backed securities or nuclear power plants, the stakes are great. When dealing with the public good and survival, laissez faire regulation is downright dangerous. We came within a hair’s breadth of destroying the financial system. Now, we have physical destruction looming as well. Nuclear power plant accidents have the potential to make large parts of Japan uninhabitable and increase death rates in Japan and worldwide.
Another “tragedy of the commons” is staring us down yet again, when individuals pursue economic self interest to the detriment of the overall society. See Tragedy of the Commons: Modern Finance and BP Parts I and II. Just as no one would question that anthrax should be tightly regulated, so should we guarantee the same stringent regulation in the current dangerous environment. Given near destruction of the financial system and negative health consequences from radioactive releases and waste, government should be imposing the strictest regulations in these two areas as if they were regulating anthrax.
Hubris Needs to Go
Overconfidence is but a symptom of the overall malady. I am all for risk taking, private profit and entrepreneurial spirit, but not at the expense of the entire welfare of our society. The emphasis on things solely financial needs to be diminished. Some would argue we are impinging on free enterprise through tight regulation. Alas, with government bailouts of the financial industry and backdoor Fed subsidies, finance is already more a ward of the state than true free enterprise. Similarly, the nuclear industry survives through federal loan assistance and limitation of liability. (See Price-Anderson Nuclear Industries Indemnity Act) Regulators need to step in, tightly but fairly, and advocate for the public interest. They can no longer be handmaidens of these two industries. Finally, from a societal viewpoint we need to think less about short-term profit maximization and more about establishing a margin of safety.
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