"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..."
at http://www.zerohedge.com/news/guest-post-when-risk-disconnected-consequence-system-itself-risk
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..."
at http://www.zerohedge.com/news/guest-post-when-risk-disconnected-consequence-system-itself-risk
