Normal Accident Theory Revisited

In 2008, I wrote about connections between normal accident theory -- which came from studies of nuclear accidents -- and the subprime mortgage crisis. In light of what is happening in Japan, I think it is worth revisiting normal accident theory. Yes, the crisis in Japan was caused by a natural disaster, but nuclear plants are systems and I am sure we will be learning a lot more about these systems in the days ahead. As we learn more, it will be useful to keep normal accident theory in mind.

So here is an excerpt from my original column which you can find here.

"The issue is not risk, but the issue is power, the power of elites to impose risk upon the rest of us." -- Charles Perrow, Yale Professor of Sociology

Normal accident theory was developed by Yale Sociologist Charles Perrow after the debacle at Three Mile Island. Perrow's fundamental insight is that "accidents" are, in fact, normal events. Rather than blaming failure on a bolt from the blue, we should expect that in any complex system -- a nuclear reactor, the stock market, housing -- there will sometimes occur a series of unusual outcomes which, taken individually, will not trigger a horrific accident. But put them together and you get a crash.

In developing normal accident theory, Perrow found the "interconnectedness" inherent in big systems often led to "baffling" outcomes. In the case of the subprime meltdown, those interactions involved the Federal Reserve, the housing industry, global financial markets and the huge piles of investments managed by hedge funds and banks. Fed Chairman Ben Bernanke recently cited these pools of cash as a factor contributing to the market turmoil.

Between 2000 and 2003, the Fed kept money cheap, lowering interest rates aggressively in order to head off a potentially debilitating spiral of deflation. That decision left these large pools of cash hard-pressed to find good investments. Investment banks saw this pool of capital and decided to create new products made from bundles of mortgages which would meet the demand for higher returns. [It is worth noting another complex interaction: US Treasuries were basically not available to these investors, because the Chinese buy so many of them in order to keep their currency fixed to the dollar.]

It all worked well for a while. But then, as Perrow's theory suggests will often occur, unfamiliar and unexpected things began to happen. Wall Street, seeing a large demand for these new financial products tied to mortgages, began to press home mortgage lenders to increase loan volumes. People with little or no credit began to get bigger and bigger loans. Seeing the success of the bundling of mortgages -- "securitization" is the technical term -- bankers began to use these same techniques in other markets. Loans for buyouts come to mind. Volumes increased and the system began to grow, becoming even more complicated.

Financial markets are also systems that are, as Perrow puts it, "tightly coupled." An action in one system directly impacts and depends upon an action in another part of the system. That is a fair description of the mortgage and securitization process. Loans have to be originated; they must be packaged and quickly sold into the secondary market. There is only one path to success here -- sales into the secondary market. No one wanted to keep these loans on their books, and indeed, seemed to have no contingency for doing so.

Once the pieces began to come apart, there was so little slack in the system no one could engineer a quick fix. Even today, the dispersed nature of bundled securities makes it difficult to rework loans into a structure that makes economic sense.

But it's not enough to understand that our financial and housing markets were flawed and subject to complex interactions. People were also at work here. Someone needed to strike the match and set the lighter fluid burning. In that sense, the housing collapse was not a normal accident. The engineers at Three Mile Island were unaware of the complex interactions between systems that threatened a meltdown. If they had been, Perrow says they would have acted quickly to prevent disaster.

Perrow thinks traders and bankers and mortgage brokers did not try to stop the financial meltdown, because financial markets offer substantial short-term gains, even if it's clear there will be dire long-term consequences. . . .

To get back to the original question: "Who allowed this to happen?" People up and down the system allowed this to happen, because there was no real mechanism to hold them directly responsible for their actions. Many will try to regulate our way back to a safer housing and financial system. I would suggest the best way to start thinking about that process is to focus on accountability. When something goes wrong in a nuclear power plant, the engineer is trying to save his own life along with the lives of those living nearby.

If we want to make sure this doesn't happen again, we need to make sure the people who might cause the next financial crisis are sitting next to the reactor when the yellow caution lights begin to flash.

Source: http://www.pbs.org/nbr/blog/2011/03/normal_accident_theory_revisit.html

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