Risk taking behavior: Rethinking Cultural shenanigans for Market failures

This article is enthused by the piece that appeared on this website titled “Risk taking behavior: Another look at the Ethiopian economy”. The writer should be commended for raising and intelligibly presenting his thought on the subject. The writer mostly argued that risk has besieged technology progress that could have transformed the Ethiopian economy. However, attributing lack of technological growth to risk averseness which in turn is to be explained by cultural reasons per se is a big leap of faith. Private investment would be suboptimal just because of cultural reasons (cultural trap as the writer calls it) is an argument that needs a stronger mast to stand. Even when we accept the writer’s notion of culturally entrenched risk averseness; it does not necessarily follow that technological progress would be hampered. And the subsequently offered raison d'être for the expansion of an already emboldened and overstretched state rests on flawed premises and carries little credence. If the state is to intervene, it would entirely be for a different reason.

It’s true that risk averseness and bad cultural practices prevent people from adopting better and novel technologies and from making profitable investments. A person is considered risk averse if he prefers a sure outcome than a fair bet offering the same expected value as the latter. For example, a risk-averse person is not willing to play a game that pays him 1 birr if a flipped coin comes up head and costs him 1 birr if it comes up tail. However, this type of people would be willing to engage in risky yet potentially profitable activities as long as the riskier option can be covered by insurance and there is enough liquidity to pay for the insurance premium. Thus, lower adoption of riskier options has more to do with lack of credit and insurance markets than a culture of fear. If the latter is there, it is precisely because these markets fail. The way insurance markets works enables even an inherently (culturally) risk averse society to transfer part of its risk to the insurer through premium payment in a good state of nature to reparation when future shocks materialize. For example, no credit market implies a farmer would usually find it difficult to borrow against his future income as his most valuable asset, land, cannot be used as collateral. Also, he is reluctant to experiment various farming techniques and inputs that can potentially improve productivity if markets for insurance are lacking to cover the risky nature of such activities.

And this is exactly what the safety-net programs have been doing in Ethiopia. The existence of the public works program has enabled farmers to smooth out consumption even during shocks such as drought or overtly wet weather. This means the long term economic effects of drought such as selling off assets (cattle), which are the only resources poor people have, can be significantly reduced. Regardless of their culture, the guarantee provided by the program in case of crop failure or animal death is akin to a sort of insurance scheme for vulnerable people.

Indeed, the seminal work by Theodore Schultz in 1964 popularized the idea of "poor but rational" people. If markets are effectively working and if poor people can collateralize their assets and insurance is present to mitigate both idiosyncratic and common shocks, there is no reason to believe that poor people would act irrationally due to cultural or religious reasons. Investor would also be making risky investments as long as the expected rate of return on risky investments is significantly higher and includes a premium (reward) for taking greater risk than the payoff they could have gotten under safer investment options. Again as long as there is a market for high return investments and insurance to partly mitigate the risk, no culture of “cautiousness” or “aloofness” can prohibit profitable investments. Without being bogged down into the chicken or the egg causality conundrum, this writer believes that risk averseness is more of an economic response to market failure than a trap induced by culture. Once we control for market forces, one fail to see any element of the Ethiopian culture that makes our society more risk averse than say a farmer in Bangladesh or a peasant in rural villages in Kenya.

The increasing penetration of rural quarters by various microfinance schemes aiming to provide liquidity to the poor is an attempt to resolve credit market failures while the ingenious creation and experimentation with weather insurance schemes in some parts of Ethiopia grew out of the understanding of the need to beef up the resilience of farmers in case of shocks. The former is particularly important as it enables farmers to use the credit market available (from informal sources and microfinance) to raise funds and engage in more profitable activities (adoption of high yield varieties and new farming techniques) albeit the higher risk it entails. It’s also worthy to note that the traditional sharecropping arrangement in many agrarian societies including Ethiopia emerged in response to its advantage in spreading risks between tenants and land owners.

The government can significantly contribute to the working of these markets through various means. One strategy could be encouraging the existing community insurance schemes such as Iqubs and Idri, which often work incredibly well when shocks are idiosyncratic or individualized. Greater financial integration of the rural areas can create liquidity and governments backing of weather insurance schemes can to some extent make risky rural investments viable. The government can also provide partial guarantees (act as an insurer) on investment areas where the risk is too high while the social benefit is tremendous.

However, this writer believes that just because government has the power to intercede does not mean it merits intervening whenever problem exists. If failures in insurance and credit market have been stifling profitable investments, the way out would be straight forward, more financial integration and greater insurance schemes. If technology transfer is not smooth due to limited private incentive and capability, public officials should not be tempted to directly have a go at it rather than providing blueprints and prototypes, subsidizing trainings and skill. Such kind of interventions can improve market outcome considerably as long as they are devised to tackle the failure as directly as possible. Interventionist public policy should not be lured into tampering with a complex system, which may end up producing much public bads than goods. Another caution is the danger of bringing political ideology to inform policy decision contrary to what the reality on the ground holds. Pragmatism is likely to bear fruit than a cult like believe in anything, be it on markets or a benevolent social planner. Indeed, Deng Xiaoping, arguing to let facts not ideology-guide Chinese policy path, famously said “It doesn't matter if it is a black cat or a white cat. As long as it can catch the mice, it is a good cat”.

By Girum Abebe

PhD candidate in Industrial Development

@ National Graduate Institute for Policy Studies (GRIPS)

Email girumpop@yahoo.com; phd08013@grips.ac.jp

Tokyo, Japan.