My title extends the humorous theme of I found in an article by Dr. David S. Pisetsky’s (M.D., Ph. D). Pisetsky’s riff is that he was eager to become famous by announcing “Pisetsky’s Rules” about rheumatology treatment risks and discovered to his great disappointment that Sam Peltzman had got their first and the risk phenomenon Pisetsky wished to warn about was already known as the “Peltzman effect.”
Here is how Peltzman’s economics colleague at U. Chicago describes the origins of the “Peltzman effect” hypothesis and research testing the hypothesis’ predictive power.
An introduction to the “Peltzman Effect”
Steven Levitt entitled his December 9, 2006 column: “The difference between ‘theoretically possible’ and ‘important.’” Here is the column in its entirety so that the reader can have confidence that I am not quoting him in a manner contrary to context.
“Academics, myself included, love coming up with counterintuitive arguments that change the way people see the world. The media probably loves to publish such articles even more than the academics like to find them.
Sometimes, though, these same academics/media do a big disservice by raising issues that are theoretically possible, but not at all important in reality.
A great example appears in this article in Time magazine about how maybe seat belts don’t save lives because drivers become more reckless when belted because they feel safer. This effect could reduce, or even reverse the safety benefits of seat belts.
The theory is sensible. When I am unbelted, I am at greater risk for injury, so I may drive more cautiously. In economics, this idea is attributed to my friend and colleague Sam “Seatbelt Sammy” Peltzman in the 1970s. Economists call this tendency the “Peltzman Effect.”
In practice, though, the evidence could not be clearer that seat belts are an incredibly cost effective way of saving lives. (See for instance, this study of mine and the citations therein.) Whatever small offsetting impact that more reckless driving due to seat belts may have, it is trivial compared to the benefits of wearing a seat belt. Articles like the one in Time Magazine encourage people to come to completely the wrong conclusion on this question.
If, however, I’m wrong and compensating behavior on the part of drivers really does undo or reverse the benefits of seat belts, there is an easy public policy solution: the government should mandate the installation of a razor sharp knife on every steering wheel aimed directly at the heart of the driver. Just think how carefully we would all drive then.”
The last paragraph is even more devastating when we consider private decision-making. No government action is required. Peltzman can install Levitt’s lethal knife on his own, and his loved one’s steering wheels. No one believes that Peltzman ever believed his hypothesis enough to think for even a microsecond about installing a knife on his steering wheel pointed at his, or a loved one’s heart. It’s a classic example of “revealed preferences,” as we say in the economics business. Does anyone think Peltzman would teach his kids not to buckle their seatbelts?
If you think Levitt’s denunciation of “my friend and colleague Sam “Seatbelt Sammy” Peltzman” was harsh, you have to consider the tenor of discussion that U. Chicago economics’ department and its allies at the law school cultivate.
“A burst of Keynesianism should surprise no one, [Peltzman] argues. Of course we hope the government can step in and save the economy. In a crisis people ‘become infantilized and go back to what’s comforting to you as a child.’”
People who believe in economic theories that have consistently shown predictive success, unlike the Chicago School’s record of disastrously failed predictions, are “infantile.” Peltzman is on the zany side even of U. Chicago.
Peltzman anti-regulatory zealotry on behalf of plutocratic funders and plunderers
Peltzman has been the most extreme proponent of the three “de’s” – deregulation, desupervision, and de facto decriminalization at U. Chicago and that is a powerful statement given that Peltzman was an ally of George Stigler. Stigler led the unholy war on regulation, supervision, and the prosecution of elite white-collar criminals at U. Chicago that was funded by Scaife, Bradley, Lilly, and Olin plus big pharma and big oil. There was nothing subtle about U. Chicago’s enthusiastic enlistment in the cause of the most anti-social plutocrats in America. The Wall Street Journal praised Treasury Secretary William Simon, who ran the Olin Foundation for decades, for ensuring that the Foundation funded only academics who shared John Olin’s overwhelming hate for the democratically-elected U.S. government, regulation, and any progressive change in law or culture.
“The senior Simon spent almost a quarter century as president of the John M. Olin Foundation, where he worked tirelessly on behalf of the idea of donor intent, making sure that those funds were going only to causes Mr. Olin would have approved of.”
The WSJ then asked William Simon, Secretary Simon’s oldest son, what lesson his father had taught him about the conditions that should be imposed even on ultra-right recipients of grants in order to try to emulate what the paper described as the revolutionary impact of the Olin Foundation.
“The Olin Foundation, with William Simon at the helm, helped usher in a renaissance in conservative ideas over the past generation.”
Simon explained that his father had taught him: “When you make a gift, you have to be very specific with the institution.”
No academic has more faithfully, and uncritically, advanced the anti-regulatory agenda of the plutocrats that funded the U. Chicago’s unholy war on regulation than Peltzman.
Pisetsky’s Rules of Rheumatology
Pisetsky doesn’t know about the myths of the “Peltzman effect.” His own rules and reasoning, however, strike me as sensible. He lists three preliminary examples of Pisetsky’s rules.
- The best way to reduce the side effects of a drug is not to prescribe it.
- Drugs come to market underdosed or overdosed. The trouble is that you don’t know which it is.
- Unless you are treating cancer, watch out for drugs that kill cells.
Pisetsky’s fundamental rule hit a responsive chord for anyone who has ever been an effective financial regulator.
“Of all the rules, the one which I think is the most important (and to which I fervently want my name attached in eternity) is this one: A drug becomes dangerous the moment that you think it is safe.
Although the reality of the Peltzman Effect can be debated, the relevance to drug safety is very clear. Any drug that comes to market carries risks and incredible unknowns, both in the short term and long term. A product approved by the Food and Drug Administration has undergone reasonable scrutiny, but the sample size of most phase 3 clinical trials is actually quite small. A trial of 2,000 people (or even 20,000 people) can tell, at best, an incomplete story. The more a drug is used, the more its risks will become apparent. If a drug is used too cavalierly, the Peltzman Effect says that the risks may quickly outweigh the benefits.
The Peltzman Effect warns, however, that prudence and vigilance remain essential in the use of these agents and that, with the passage of time, we should become perhaps more, not less concerned, about the danger lurking in the medicine chest (or in the refrigerator in the case of biological products).
Inhibiting tumor necrosis factor may be okay for five years, but after 10 years, cancer cells may stir in what for them is a salutary environment, where tumor-killing macrophages slumber and sleep. Alternately, bones may suffer catastrophic collapses due to prior microfractures that could not be healed because osteoclasts had been pummeled into submission by bisphosphonates.”
Pisetsky’s rules aren’t Peltzman Effects, they are Unintended Treatment Consequences
Pisetsky’s rules are not actually examples of the hypothesized Peltzman Effect. In the examples he provides the rheumatism drug regime does not reduce the risk of rheumatism in a manner that could lead (or does lead) to the patient taking on greater risk. None of his examples involve the patient voluntarily taking on greater risk.
Applying Pisetsky’s rules to financial deregulation proposals
Pisetsky’s rules should be instructive for anyone embracing the three “de’s,” particularly Peltzman. Note that Pisetsky is concerned that the FDA tests for drug efficacy and safety have sample sizes that cannot assure that we do not miss unusual effects on patients with uncommon genes. Pisetsky does not appear to know that Peltzman is the leading critic of the FDA and is enraged that it, in his view, conducts excessive tests of efficacy and safety. Peltzman is also the classic example of the academic who is blind to the four risks that Pisetsky presents.
Pisetsky, of course, wasn’t writing about the three “de’s” in the context of financial regulation, but it is in that context that Peltzman’s eagerness to do violence to Pisetsky’s four rules becomes apparent. There are five critical preliminary points. First, there are no typically no government supervised tests of the efficacy and safety of financial products. Second, there is no precautionary principle in finance. Third, the financial industry does not recall products that subsequently prove unsafe. Fourth, the financial sector has failed to adopt any ethical provisions remotely similar to that of physicians. Fifth, drug companies sometimes distort the efficacy and safety tests. The financial sector routinely engages in endemic accounting fraud.
Pisetsky’s four rules have analogs in finance. Consider his first three rules:
- The best way to reduce the side effects of a drug is not to prescribe it.
- Drugs come to market underdosed or overdosed. The trouble is that you don’t know which it is.
- Unless you are treating cancer, watch out for drugs that kill cells.
- The best way to reduce the side effects of new, complex financial derivatives is to not to allow them.
- New, complex financial derivatives will not perform as their designers predict. The trouble is that you don’t know how they will deviate from their promised behavior.
- Unless you are trying to cause a financial crisis in another country, watch out for financial products that have no readily verifiable market value – they are likely to prove toxic.
Pisetsky’s most “important” rule is “A drug becomes dangerous the moment that you think it is safe.” That same rule applies to financial product that produce substantial reported “income” in the early years. The root concern is the same – the high reported profits mask the reality of the deadly flaw in the product and breed complacency in the financial regulator. In both cases, the “success” reported in the early years makes it harder for the regulator to prevail in a court challenge if it prohibits the financial product or the drug. Under the “benefit/cost” standards Peltzman supports it will be exceptionally difficult for the regulator to act on an emergency basis to ban the drug or financial product when the first indications emerge that it is toxic rather than successful.
The Unintended Consequences of Private Sector Decisions
Peltzman applies his “effect” almost exclusively to regulations, but his logic would apply to private safety efforts. Companies that adopt comprehensive programs to reduce accidents should find that their workers become far more reckless. The opposite occurs. Worker injuries are obviously terrible for workers, but they are also exceptionally expensive for the company. The rule of thumb is that the indirect costs are five times as large as the direct costs of injuries. This “win-win” possibility has made it possible for OSHA, employers, and employees to work cooperatively to produce substantial overall reductions in industry injury rates. Companies that make a top level commitment to work with their workers to create a comprehensive culture of safety frequently achieve “dramatic” reductions in injuries.
The worst companies, of course, develop systems to falsely report much lower injury rates than reality. The same study reported on why workers sometimes appear to be indifferent to their safety.
“For example, if employees believe that management values productivity over safety and health, they may try to ‘work around’ a hazard and knowingly risk accidents.
But if they believe that management values their safety and health, they will often report or repair hazardous conditions—often at some loss of productivity that is acceptable to management—to avoid the potentially greater loss that an accident or illness might cause later. If a bit simplistic, this illustration demonstrates the power of a successful safety and health culture.”
A naïve research model of the kind Peltzman employs could miss this critical dynamic that requires an investigation of the CEO’s real incentive system rather than the superficial rules designed to deceive OSHA.
The Deadly Complacency of Peltzman Ignoring Accounting Control Fraud and Claiming that “Private Market Discipline” will Prevent any Abuse
By failing to understand even the existence of accounting control fraud and by implicitly assuming that “private market discipline” defeats any private sector problem, Peltzman creates a “Black Effect” that makes his embrace of the three “de’s” so criminogenic. The “Black Effect” is that by adopting “private market discipline” as the sole defense against accounting control fraud by banks, the proponents of the three “de’s” make private market discipline an oxymoron. The CEOs running or willing to run accounting control fraud adjust to the new, far more criminogenic environment after the three “de’s” are adopted by engaging in greater fraud. Private market discipline is an oxymoron. Private creditors (banks) are the primary funders of the fraud “recipe” for banks, which calls for their rapid growth. That rapid growth is overwhelmingly funded by the elite banks that are supposed to provide the “discipline.” The reality is that bank officers are eager to lend to other banks that report record profits. Accounting control fraud makes reporting record profits a “sure thing.”
The controlling officers of fraudulent bankers exploit the unique abilities that come from that control to deliberately generate a series of “Gresham’s” dynamics that suborn “controls” and pervert them into being the bank officers most valuable fraud allies. That dynamic means tht the “controls” actually aid the bank officers’ frauds.
By reporting record profits and securing enormous bonuses, the controlling officers of banks engaged in accounting fraud implicitly create a Gresham’s dynamic due to modern executive compensation. This dynamic strikes at the CFOs and CEOs of rival, honestly-run banks and creates a strong incentive for these formerly honest officers to mimic the accounting control fraud strategy so that they too can receive enormous bonuses, keep their jobs, and enhance their fame and social status. If a material number of bank CEOs mimic the fraudulent CEOs at rival banks the resultant fraud epidemic can hyper-inflate the bubble and make the CEOs even wealthier by greatly extending the life of the fraud scheme. The Black Effect explains why private market discipline, the supposed solution to accounting control fraud is actually the most valuable aid that the three “de’s” provide to the fraudulent CEOs.
The Black Effect does not require deposit insurance to weaken “private market discipline.” Even when the company is not protected by deposit insurance, which was the case with investment banks, Enron, and hundreds of other corporations, and insured banks with subordinated debt, private market discipline routinely failed to cause failures until long after the company actually failed. Unlike the hypothetical Peltzman Effect that routinely causes him to give terrible public policy advice about regulations, the Black Effect has been shown to be a critical cause of our recurrent, intensifying financial crises.
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