U.S. must start now readying for next threat

September 11, 2005|By Jay Hancock

THE FAILURE to strengthen New Orleans' levees before the arrival of Hurricane Katrina is a catastrophic collapse of risk management that carries lessons for policymakers, businesses, investors, consumers - everybody.

Risk management is shorthand for identifying, assessing and preparing for threats - killer asteroids, dicey stocks, terrorist bombs, customer defections, job loss.

Alan Greenspan's tenure as chairman of the Federal Reserve is a model of (apparently successful) risk management. Defense Secretary Donald H. Rumsfeld broaches risk management when he talks about "known unknowns" and "unknown unknowns."

Your life insurance agent would love to discuss the topic. Baltimore's Constellation Energy makes a nice living selling electricity-price hedges and other energy risk-management products.

Risk management is about the future, but it doesn't require clairvoyance. Its essence is to weigh: a) the probability of a threat materializing and b) the damage that would result. Multiply "a" times "b" and you get a good idea of what to worry about.

Low-probability, low-damage items can be dismissed. High-probability, high-damage threats are probably already being dealt with. Cancer, heart disease, drunken driving and other obvious societal risks are targets of innumerable dollars and minds.

It's the low-probability, high-damage risks that can kick you in the nose.

The crying shame about New Orleans is that the threat was not especially unlikely. It was a high-probability, high-damage risk that The Times-Picayune of New Orleans, Scientific American magazine and others had vividly warned about. Its denouement makes policymakers look like idiots.

Corporate history is rich with risk-management disasters. White Star Line and its Titanic had been warned about icebergs. Pan American World Airways and the U.S. State Department were tipped two weeks before the 1988 destruction of Flight 103 that terrorists would try to blow up a Frankfurt-embarking Pan Am plane.

The collapse of Long Term Capital Management in 1998 resulted from an improbable threat to the global financial system. John Rusnak was one employee among thousands at Allfirst Financial, but he single-handedly cost the bank $691 million in bad currency trades and caused its sale to M&T Bank. Both were risk-management failures - a disastrous discounting of both adverse event and potential result.

After the stock market collapse of 2001 and 2002, the Federal Reserve discerned a small threat of deflation - persistently falling prices. But because the potential damage from deflation was so huge - consumers could stop spending; bad debt could soar - the Fed fiercely attacked it, sharply cutting interest rates and abandoning its longtime campaign against inflation.

"The product of a low-probability event [deflation] and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue," Greenspan said a couple weeks ago.

What about you? The most significant risks to individual life and property are not the ones many people lose sleep over.

Being mugged, riding the London subway, contracting the West Nile virus, breathing anthrax or getting hit by lightning all threaten great potential damage but carry very, very low odds of occurring. Better to make sure you're exercising and eating right and ensuring your kids get vaccines and drive safely in good cars.

Greenspan worries that Americans are shouldering too much financial risk. The implication is that we're taking on too much debt and buying stocks and bonds too cheerily. His warnings, however, are mainly about moderate threats and moderate potential damage. If the stock market falls 25 percent, it might prove him prescient, but it won't make a million people homeless, as perhaps Katrina has done.

For the U.S., now is the time to seek out the next potential Katrina, to identify long-odds, high-hurt, preventable threats that could create national or global anguish. Two candidates: global warming and loose nukes in the former Soviet Union.

It is amazing that responsible adults who understand risk management ignore the concept when it comes to the greenhouse effect. Yes, there are questions about the cause and consequences of global warming, but lack of certainty is no reason not to address what may be the ultimate global risk. The "unknown unknowns" of global warming are mind-boggling.

Risk management is not about certainty. The threat to New Orleans was not certain until the dikes were breached.

And the effort to secure poorly guarded nuclear bombs in the former Soviet states is still a joke. In 2001, former Sen. Sam Nunn called the prospect of terrorists obtaining Soviet nukes "America's greatest unmet threat" and called for many billions in spending to address it. "No investment pays a higher dollar-for-dollar dividend in national security than investment in threat reduction - none," he said.

Sounds like a risk-management calculation. Too bad he was all but ignored.

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