Risk is Necessary for Adaptation, Innovation and Success   (December 21, 2011)

Ironically, perhaps, building a new sustainable future requires being fully exposed to what is considered "the source of our problems": risk, threat and failure.

While I write a lot about financial and systemic unsustainability, the primary driver of my "doom and gloom" view of the Status Quo is that risk has been neatly severed from return--a disconnect that eliminates adaptation and thus success.

Risk, threat, failure--these are three descriptions of the same feedback loop from the real world. Eliminating risk via guarantees, backstops or the transfer of risk to others appears to increase the security of the recipients--after all, now they can't lose their jobs/pensions/bonuses/contracts etc.

But by eliminating risk, threat and the consequences of failure, you've removed the critical information needed to avoid systemic failure. Sever the feedback of failure and risk, and the system loses touches with reality/consequence and runs off the rails in systemic collapse.

This is the grand irony of risk: reduce risk and the participants feel more secure, even as the risk of eventual failure rises to 100%. In effect, risk cannot be eliminated, it can only be transferred. Eliminating risk and consequences, i.e. threat and failure, to individuals and enterprises, and all you've really done is transfer the risk to the entire system.

Eliminating consequence generates perversely unintended consequences. Remove the risk of flunking out and the student tends to slack off; why bother studying if you're going to pass anyway? And if the feedback (in the form of consequence) from the real world is discounted, how much learning takes place?

The same mechanism spawned the credit/housing bubble and the mortgage/robo-signing mess: lax or non-existent regulations and zero enforcement gave a free hand to risk-free speculation, predation, exploitation, fraud and embezzlement. The term "moral hazard" simply means risk has been disconnected from return and consequence.

The results of this disconnect are always and necessarily catastrophic.

Imagine being in a casino where all your bets are covered or backstopped by the Federal Reserve; any losses generated by your gambling will be transferred to others, while any gains are yours to keep. That is the U.S. banking/mortgage system in its purest essence.

We can extend this to Savior State guarantees that most now take for granted as "secure" and permanent: Medicare and Social Security. We can summarize exposure to risk, threat, consequence and failure very simply: if you're exposed to risk, threat, consequence and failure, then you act differently than if you're not exposed to these feedbacks from reality.

The essence of entrepreneurism is that gain cannot be reaped without exposure to risk, threat, consequence and failure. The essence of crony capitalism/cartel capitalism is that risk, threat, consequence and failure are off-loaded onto the taxpayer by the Savior State, leaving the State's private partners with all the gains while the losses are transferred to the public/taxpayers.

Our entire system is now based on transferring risk to others and severing the feedback from the real world that is expressed as risk, threat, consequence and failure: farm price supports, the military-industrial complex (when was the last time a "defense" contractor went bust?), the corrupt banking system, the sick-care system (Medicare, etc.), guaranteed loans, guaranteed lifetime employment, bail-outs, stock markets which are never allowed to decline, and on and on.

Does anyone seriously think incumbent politios are at any great risk? Due to the corruption of big-money contributions and lobbying, the vast majority of incumbents win re-election. No wonder they engage so fiercely in empty political theatre; they don't feel any threat of losing their power and perquisites if they don't tackle the really difficult issues.

Eliminate feedback and you doom the system to mal-adaptation and thus collapse. The "security" created by the welfare State (corporate and individual welfare) is entirely superficial: all that has occurred is the risk has been transferred to the system, which is starved of the information it needs to adapt, i.e. risk, threat, consequence and failure.

As long as Americans prefer the superficial "security" of shunting risk, threat, consequence and failure to someone else or the system at large, then we are dooming ourselves and the Status Quo to systemic failure and sudden "unexpected" implosion.

It's funny, isn't it? Real security flows only from the constant dynamic of adaptation fueled by the information and volatility of risk, threat, consequence and failure--the very feedbacks we ruthlessly eliminate with paper-money "guarantees," "loans," backstops and empty promises.

Nothing has been fixed in the past four years; all we've done is borrow and squander $6 trillion from our children and their children to prop up the Status Quo, print trillions of dollars via the Federal Reserve and backstop insolvent banks to the tune of $7.7 trillion in secret giveaways and free-money loans.

Printing and borrowing $14 trillion in four years has solved nothing, but it has transferred the risk and consequence from all who would have failed in a reality-based system to the entire system. This is why the Status Quo is most certainly doomed: risk has been transferred to the system as a whole, where consequence is easily lost in thousands of pages of obtuse legislation and shadow systems of banking and governance.

Risk and failure are necessary for adaptation, innovation and thus for success. Suppress or transfer risk and you've eliminated the possibility of sustainable success.

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc. Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

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