When Risk Is Disconnected From Consequence, the System Itself Is at Risk   (February 22, 2012)

If we understand risk cannot be eliminated, it can only be transferred, then we will understand why the current financial trickery in Europe and elsewhere is doomed to fail.

The entire global economy's fundamental financial instability can be traced back to one simple rule of Nature: risk cannot be eliminated, it can only be transferred to others or masked. And when it is transferred to others or masked, then the causal feedback between risk and consequence is severed.

Once risk has been disconnected from consequence, then it is impossible to discover the price of capital and risk. Once capital and risk have been mispriced, then the inevitable result is misallocation of capital and a positive feedback loop of self-referential, self-reinforcing risk.

Once the causal negative feedback of the real world--consequence--is no longer available to those taking on risk, then only positive feedback remains. Positive feedback inevitably leads to runaway reactions that self-destruct.

This can be illustrated by imagining yourself in a casino where a consortium will guarantee your losses up to $1 million. We call the disconnect of risk from the resulting gain/loss "moral hazard," and to understand the ramifications of moral hazard, we need only compare the actions of two gamblers in the casino: one is using his own money, the other has none of his own capital at risk, and his losses will be covered up to $1 million.

How much risk will you take on in gaming if you can lose $1 million without any loss to yourself? Obviously, we will accept enormous risks because if we win the high-risk bet, the gain will be ours to keep. Low-risk bets yield low returns but high-risk bets yield high returns.

If our losses will be transferred to others, then why waste time betting on low-risk, low-return "red" at the roulette wheel? Let's bet on single numbers because the payoff will be astronomical.

If we actually score a few high-risk "wins," this success feeds our risk appetite. This is a positive feedback loop: our wins reinforce our risk appetite, while negative feedback (the losses from losing bets) no longer register--they have been eliminated from our calculations of risk and gain.

This positive feedback eventually leads us to make stupendously large bets. Eventually, we bet $1 million on a high-risk play and lose. We are wiped out, but oh well, it was fun while it lasted. If we were especially disciplined and clever, we squirreled away some of our winnings in our own account: we kept the gain and the consortium took all the losses.

The risk didn't vanish, it was simply transferred to others who now bear the cost of the unfettered risk being played with abandon. The consortium who financed the no-risk gambling spree now has to absorb the $1 million in loss. If the consortium masked its own risk by presenting a phantom financial security to the casino, then the casino will have to absorb the loss.

In effect, the risk was transferred to the entire system. Since the consortium is made up of many investors, and the casino has many investors, then the risk and loss was effectively spread over many participants. The $1 million loss, catastrophic to any one player, is effectively distributed to everyone in the system.

When losses are trivial compared to the size of the system, then this distribution of transferred risk results in a modest loss to all participants.

But let's suppose the player with the $1 million backstop was extraordinarily successful with insanely high-risk bets, and he built the $1 million stake into $100 million, which he then rolled into several stupendous bets.

He loses, because the risk of gambling hasn't been elminated, it has only been masked and transferred to others. Now the consortium faces a loss 100 times its guaranteed backstop, and since its capital is only $10 million, it is also wiped out and leaves the casino with $90 million in uncollectible debt.

If the casino needs that $90 million to pay its own speculative debts, then it too will be wiped out.

This is how one player who manages to mask or transfer risk to others can bring down entire systems. The risk only appears trivial and manageable at the start, but since the negative feedback of consequence (reality) has been eliminated from the players' perspective, then risk piles up in a self-reinforcing positive feedback.

Since the system itself has disconnected risk from consequence with backstops, guarantees and illusory claims of financial security, then it is has lost the essential feedback required to adapt to changing circumstances. As the risk being transferred to the system rises geometrically, the system is incapable of recognizing, measuring or assessing the risk being transferred until it is so large it overwhelms the system in a massive collapse/default.

The consortium has only two ways to create the illusion of solvency when the punter's $100 million bet goes bad: borrow $100 million from credulous possessors of capital or counterfeit it on a printing press. These are precisely the strategies being pursued by central banks and states around the globe. BUt since risk remains disconnected from gain/loss, then capital and risk both remain completely mispriced.

Risk is being transferred to the entire global financial system at a fantastic rate, because counterfeiting money or borrowing it on this scale to cover losses creates new self-reinforcing feedbacks of risk.

As long as risk is being masked or transferred to others who don't reap the gain, they only reap the losses, then the system is doomed to self-reinforcing instability and eventual collapse.

The only solution is to enforce the causal connection between risk and consequence: those who took the risk have to absorb all the loss. Since risk cannot be eliminated, it can only be masked or transferred, then all the tricks that are being played out in Europe, China, Japan and the U.S. are only enabling risk to pile ever higher in the system itself.

At some unpredictable stick/slip point, the accumulated risk will cause the system to implode like a supernova star.

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