Designing the Orderly Failure of Large Institutions

Continuing the discussion of how to plan the compulsory failure of institutions that, believing themselves "too big to fail," are in fact too big for human society to afford.

If the wave of unemployment accompanying Washington’s post-recession care and feeding of guilty financial giants at the expense of American society did not make clear that Paulson’s concept of the “orderly failure of large financial institutions” was poorly implemented, then the wave of foreclosures did. While many Americans were clearly playing the (housing) market in full recognition that they were trying to benefit from a giant chain letter that would hurt only the last owner of their grossly inflated mortgage, thousands of other Americans unable to pay their mortgages because Wall Street irresponsibility had cost them their jobs had their homes taken by selfish banks who, once back in possession of the houses, could not find anything to do with them except let them rot. The Bush-Cheney-Paulson billionaire bailout, so uncritically supported by Obama, may have exemplified “orderly failure” for the billionaires, who kept the profits of their crimes, but was anything but “orderly” for the millions who suffered.

All that is of course rapidly becoming old, well-understood, and quickly-being-pushed-under-the-rug history. The whole U.S. financial and political elite-- from Wall Street, Washington, and many other places—was essentially complicit and has little interest in looking too closely at issues of responsibility. But for American society, not to mention the rest of the world, the issue, beyond punishing the guilty in the name of justice, is to determine exactly what a socially responsible process of orderly failure for a large institution would look like.

“Moral hazard” provides guidance. Institutions should be restructured and downsized (e.g., by preventing banks from playing the market with homeowners’ mortgages or savings accounts) to minimize socially harmful behavior and maximize socially beneficial behavior. Decision-makers at those institutions should be held personally responsible. Filling jails with brokers has little obvious value to society, but when a financier gets rich by inventing incomprehensible but obviously dangerous (because highly leveraged) financial “products,” the burden of proof should be on him to justify why all of his earnings should not be confiscated to compensate for “collateral damage.”

In truth, society needs to understand its frailty and, more, appreciate how often failure is due not to natural constraints or normal human limitations but to egregious cheating on the part of the powerful, who regularly kill the social goose that lays the elite’s golden eggs. Paulson deserves credit for enunciating the highly counter-cultural concept of “orderly failure.” American society, as the global leader (no moral judgment here; I mean the phrase simply as honest recognition that the U.S. is the biggest elephant in the room), needs to take primary responsibility for developing not just the biggest war machine, the greediest financial district, and the most wasteful consumption society but also the global standard for institutional rejuvenation.

The U.S. has done it before. With the Marshall Plan, it transformed Nazi Germany and the Japan of military imperialist dictatorship into pillars of democracy. By its very establishment, the U.S. also transformed a West of kings into a West of republics. It then transformed itself from slave society to free society. Those were truly institutions “too big to fail.”

But those transformations were seen as unique. No user’s manual existed, nor were the respective situations perceived as members of a class, so no user’s manual was written despite the priceless lessons. Political science has failed us here. No busy government official will ever have time to study the crises and develop a generic process for smoothly cleaning the rot from failed institutions; that would be the responsibility of a new sub-field of political science, a field that would recognize theoretically the need for institutional renovation by force from the outside and that would recognize theoretically that the word “institution” comprises private and public institutions, companies and countries.

The process occurs every day. With the brilliant insight of Gorbachev that military force to maintain the existence of the rotten U.S.S.R. would be inappropriate, that empire was transformed, but of course via a decade of depression and crime—hardly an example of “orderly” failure. We await the first book to do a comparative analysis of the financial mess of Soviet communism and Wall Street capitalism…of the corruption of nomenklatura vs. the corruption of derivatives. A follow-on study could compare the corruption of Soviet industrial pollution vs. the corruption of Western Big Oil’s rape of the environment from Nigeria and Bolivia to the Gulf of Mexico. From such studies, done properly, would be derived a set of generic lessons of inestimable value for designing a well-functioning society.

While this task of assessing key crises of institutions failing from a social perspective even as they functioned brilliantly for the elite who benefited personally is likely to take a century to complete (and will require a profound understanding of how complex-adaptive systems operate in the social arena), we can usefully begin with a few obvious (once stated, albeit mostly ignored in current practice) principles:

• The principle that the larger an institution, the greater its responsibility to behave in accordance with the common good should be established in law;
• Rules for behavior should be known in advance;
• Rules should spell out personal responsibility for institutional elites and governmental regulators;
• The assumption should be that in egregious cases (e.g., breaking rules about leveraging, ignoring engineers’ warnings about installing good quality environmental protection equipment), decision-makers and their management chain will forfeit all personal earnings gained as a result of irresponsible decisions. Any claim that one deserves exemption (e.g., a golden parachute for a Wall Street CEO or denial of personal responsibility by an oil executive after a pollution spill) should have to be made publicly in court;
• Just as buildings have plans for getting people out in a fire, institutions should have plans for emergency downsizing.

And every American should realize that the need to grade the social acceptability of big institutions applies not just to brokerages and oil companies but to the United States as a whole…today. Americans are far more skilled at building huge institutions than in building socially beneficial institutions. More seriously, until disaster strikes, the assumption, deep in the culture, is typically made that big is better...rather than more dangerous. In fact, national downsizing of a rather bizarre type is the constant refrain of a certain class of conservatives (not those who “conserve” but those who believe in freeing the rich to do the exact opposite by forcing “conservation” down the throats of the disadvantaged). These “conservatives”, more properly these “elitists,” want not conservation by society but conservation by government. This is at least a step in the direction of downsizing, but one informed less by the theory of how to make institutions perform better than by raw greed. Nevertheless, this concept of downsizing is worth keeping, so long as the focus is shifted from downsizing regulation of, to be frank, piracy, toward the downsizing of socially pernicious behavior. Mankind has been stumbling in this direction for millennia, though the decades since Reagan entered the White House have seen the U.S. move in the opposite direction.

Part of the difficulty of making progress toward more socially responsible behavior by large public and private institutions lies in the lack of theoretical understanding of the concept of social responsibility for all large institutions. Society has no clear generic standard for the behavior of large institutions as a class. Seeing the generic issue rather than just the individual crises would facilitate asking questions in a way that would promote deeper understanding. How might one compare the harm to Iraqi society caused by the U.S. army during the occupation with the harm to U.S. society caused by the capricious approach of many banks to foreclosing on American homeowners? While this may seem at first glance to be an odd question, to ask it focuses attention on how to balance an emergency need to use force in a crisis vs. the long-range costs of force as the tool for conflict resolution. As technology improves, we gain the ability to approach closer and closer to the edge of chaos, a great achievement as long as we do not fall over the edge, but one that is becoming too dangerous without a deeper theoretical understanding of when institutions, including superpowers, become too big not to fail.