I’m continuing to read my way through Hilary Allen‘s Driverless Finance.  The first chapter breaks down the need for financial regulators to embrace the precautionary principle. 

At the outset, Allen draws a distinction between measurable and manageable risks and true Knightian uncertainty.  Essentially, Knightian uncertainty refers to those “unknown unknowns” where no real way to evaluate risks exists.  Allen seems correct that an inability to precisely measure risks doesn’t mean we should just trapse forward into the uncertain future without taking reasonable precautions and regulating with an eye toward preserving financial stability.  She details the human costs of financial crises by looking at the widespread harms fairly attributable to the 2008 financial crisis.  These kinds of events wreck economic growth and they wreck lives.  People die.  They die from depression, suicide, foregone preventative medical care, and from other reasons attributable to these crises. Although a financial crisis visits widespread harm across the globe, the damage isn’t spread evenly across society.  The most vulnerable pay the cost. 

Allen convinced me that when we’re evaluating financial innovation, we shouldn’t blindly trust innovators to take systemic risks into account.  Innovators are poorly positioned to think about how competitors and the financial system as a whole may respond to the introduction of new technology.  Innovators also have the wrong incentives.  Financial stability benefits everyone, but innovators may personally benefit from introducing innovations that make them rich while driving up systemic risk.  Once you have enough cash on hand, you’re likely well-insulated from any global catastrophe financial innovation may unleash.

This means that we need to have properly-resourced regulators participating in the integration of new financial innovations into the financial system.  This requires investing in expertise and ensuring that regulators have the ability to understand new innovations.  Appropriately skeptical regulators will be positioned to restrain developments that needlessly increase complexity and risk without helping the financial system do its actual job any better.  Allen explains that we already take this approach with introducing new drugs into the market.  The FDA requires pharma to establish safety and efficacy before dosing millions.  This may be an easier sell because people can easily envision the costs of medical mistakes.

To help the reader see and understand the problem, Allen asks the reader to envision what would have happened in 2008 if credit default swaps had been automated through smart contracts.  When AIG faced collateral calls from Goldman because of its CDS contracts, the parties negotiated and reached a resolution, allowing time for Congress to come through with a bailout.  Smart contracts automatically executing capital calls could have thrown AIG into instant insolvency.  

Allen’s likely right that inaction on financial innovation now increases risks.  It may also make it much harder to restrain innovation as the crypto-asset industry grows.  With crypto swelling from billions into trillions, freshly funded hordes of lobbyists see poised to descend on attempts to restrain financial innovation.  A profit-maximizing industry aiming to forestall regulation will likely point to compliance costs, foregone profits and other “losses” they will experience if regulators restrain or shift the course of financial innovation.  There may be some real costs to adopting a thorough precautionary approach.  But we must also counterbalance this and count the cost of a financial crisis.  Successful financial regulation may always be decried by opponents looking at a lopsided ledger.  They see only the industry’s expense and never take into account the costs of a crisis sensible regulation may avoid.

On the whole, Allen makes a convincing case for embracing a precautionary approach to financial innovation.  She acknowledges the necessary tradeoffs and makes a strong case that it’s worth it to venture cautiously into the unknown.