Risks of Risk Avoidance

Life is full of risks. It may be that most risks can be avoided. Avoiding risks also avoids benefits.

Take, for example, the case of Wikileaks. The failure to share information among government agencies contributed to the attacks of September 11. But sharing information carries the risk that someone with access will abuse that access.

Or take the case of Solyndra, the risk of government guaranteed loans against the possibility of a technological breakthrough. No risk, no breakthrough. That outcome is certain.

The best comment on that issue, and the most appropriate cautionary advice, was posted today by economist Jared Bernstein:

Solyndra, Risk, and Risk Aversion

Sep 17, 2011

The bankruptcy of Solyndra, a solar panel manufacturer that got a government loan of over $500 million from a (GW Bush era) loan-guarantee program, is garnering a lot of headlines.   Opponents of the administration are salivating at the opportunity to use this as an example of all things bad about activist economic policy, “picking winners,” and so on.

De facto, this was a bad investment choice.  And if it was influenced by anything other than the objective risk analysis, as some critics are alleging, that should be brought to light.

But if this episode, amped up by the intense private market ideology of our time, leads us to become totally risk averse in terms of government’s investment agenda, to shut down our efforts to foster innovation in clean energy, for example, we will deeply undermine our economic future.

Solyndra’s potential edge was that the company figured out a way to make solar panels without polysilicon, a key ingredient in solar panel construction, and one whose price looked high and volatile through the mid-2000s, making the Solyndra investment an interesting and potentially useful hedge.

But as this NYT article points out, the price fell steeply and the decline appears to have largely occurred before the loan was finalized:

“…the price drop meant that before Solyndra had received a single DOE loan guarantee dollar, a major part of its cost proposition had been undermined, if not erased.”

I’ll get back to that part of the case in a moment.  My point here is to remind us why it’s important for gov’t to make these investments and why the wrong lesson from this case would be to turn tail and run from such public/private endeavors.

There are many reasons for the federal government to play a role in this part of the market, ways in which the market historically fails to adequately invest in potential technological advances.  They come under the rubric of negative externalities—barriers that block market forces from delivering what we need, including barriers to entry, expansion, coordination, and innovation that no single, private firm can solve on its own.

–Research Barriers: R&D can be prohibitively expensive and few firms can support the amount of research needed to advance new endeavors, like advanced battery or solar technology.

–Coordination Barriers: No single firm could coordinate national projects like the internet or smart grid

–Innovation-to-Production Barriers: Firms need help getting out of the “valley of death,” that period between discovery of an innovation and the development of the production processes that enable it to be affordably adopted by society.

–Credit Barriers: Markets will underinvest when returns are particularly uncertain—it’s a classic externality in that firms cannot typically recover the costs of R&D in new areas of research.  Eg, when the internet was just an idea, too few private lenders, including venture capitalists, would support basic research on the idea.

–Exports: Firms need the federal government to help open export markets and pushback against unfair trade practices.

So how do we square these perfectly reason rationales, ones adhered to in every advanced economy, with our perfectly reasonable desire not to waste valuable taxpayer dollars on bad choices?

The answer is that we must recognize and accept some credit risk.  There will be cases when research goes down fruitless paths and when a hedge like Solyndra turns out to be trumped by ensuing events.  Risk analysts deciding to guarantee the loan in this case may have legitimately believed the price decline in polysilicon would soon reverse and that it made sense to foster an alternative.  But they may also have missed an important structural shift in supply and demand.

Either way, the key word is “risk.”  We can totally avoid such risk, but in so doing, we will unquestionably hurt our long term economic prospects.  Think about the development of early machine tools that gave rise to manufacturing, railroads, transistors, lasers, satellites, and the internet.

In every case, some or all of the above externalities/barriers were present.  Had the gov’t practiced the level of risk aversion now being advocated in the wake of the Solyndra bankruptcy, the private market would not have developed them, at least not here in America.

Think about that the next time you use a cellphone, GPS, or post or read a blog.  We should always strive for better, more accurate risk analysis.  But if we try to avoid any risk at all…well, then we can enjoy ourselves kicking back and watching the rest of the world pass us by.