Wednesday, August 21, 2013

The Source of Systemic Crisis: Risk and Moral Hazard

Programs that backstop banks and social insurance systems like Medicare are not like fire or life insurance, and therein lies the source of systemic crisis.

There are all sorts of candidates for the root cause of the systemic global financial crisis, but if we separate the wheat from the chaff we're left with risk and moral hazard. Pointing to human greed and cupidity as the cause doesn't identify anything useful about this era's crisis, as human greed, self-interest and opportunism are default settings.

That institutions have failed is self-evident, as is their inability to structurally reform themselves. If we ask why this is so, we eventually come back to the source: risk and moral hazard.

The key to understanding risk is to ask where it is being offloaded. Risk cannot be disappeared, it can only be transferred or cloaked. The question is: who is it being transferred/offloaded to? What are the consequences of risk pooling up in these reservoirs?

Moral hazard is a fancy way of saying those who have no risk act quite differently from those burdened with risk. Here's an easy way to grasp the concept: imagine two gamblers in a casino. One is backstopped up to $1 million by a wealthy patron; every loss he incurs will be made good until the $1 million is consumed.

The other gambler has only his own cash to put at risk.

Moral hazard means risk has been separated from consequence. The backstopped gambler can make hugely risky bets with abandon because the risk of losses have been offloaded to the patron. There is literally no consequence to losing speculations until the backstop is exhausted.
The gambler using his own cash is exposed to consequence at every bet: a few bad bets and he's busted, broke, and unable to continue gambling.

The systemic backstopping of speculative losses incurred by banks was and remains the source of the global financial crisis. Simply put, systemic moral hazard leads to self-reinforcing feedback loops of risky bets and catastrophically poor decision-making by speculators and policy makers.

One time-honored way to offload risk is insurance, which pools risk and distributes it among the participants. Buying fire insurance on the family home for a $1,000 annual premium makes sense for the owner and for the insurance company because few homes burn down every year. Indeed, most homes never burn down.

But what if every home burned down once a decade? The costs of fire insurance would be radically higher. This highlights a critical distinction between two types of pooled-risk insurance: risks of events that are random and rare, and risks of events that are certain to occur, such as death and illness.

Death is certain, and so life insurance is based on the certainty that the policy holder will pass away. The odds of any policy holder passing away in any one year can be calculated actuarily with some accuracy, enabling the profitable business of life insurance, which became widespread in the 19th century.

Health insurance is similar, in that the vast majority of people will become ill at some point in their lives and will require medical care of some sort. Most people become ill as their lives draw to a close, and the probabilities of this are calculable.

There is another key difference between these two types of pooled-risk insurance:the total cost of replacing a home that burned to the ground is easily estimated, as is the market value of the existing home. The same can be said of autos.

Healthcare and pensions are open-ended. As new procedures and medications become available, the costs of managing chronic diseases rise dramatically. Systems that were based on average lifespans of 64 years and a few weeks of palliative care for the dying are no longer financially viable when the average lifespan is 84 and multitudes of participants are living for years or even decades with costly chronic diseases.

Pension systems are not insurance. The returns on funds invested are unpredictable, and so are the costs of retirees as people live longer and benefits are extended. Pensions are not distributed-risk/cost systems: their earnings are intrinsically risky while the benefits are essentially open-ended.

Some risks cannot be quantified with any useful accuracy. What are the odds that the global economy enters an extended period of low-growth/stagnation? Were this to happen, the majority of pension funds based on sustained high rates of growth will fail to produce the returns needed to fund promised pensions.

It turns out to be remarkably difficult if not impossible to accurately predict macro-events and trends and the risks they present. Though many hold out hope that Big Data (crunching hundreds of billions of data points) will enable accurate forecasting, the innate difficulty is that correlations uncovered by Big Data do not imply causation.

That means correlations can arise and vanish as new data sets are crunched.

The past is not necessarily an accurate guide to the future, and so assessing risk and probability of macro-events and trends is not just a matter of extending current trendlines. How many analysts in 1985 set the probability of the Soviet Union dissolving within five years at 90%? The dissolution of the U.S.S.R. wasn't even on the spectrum of "realistic possibilities" a mere five years before it evaporated.

Every model has biases: filters, smoothing, and so on can be adjusted to get the desired output. In the case of states (governments) and institutions. there are powerful biases in favor of the status quo being presented as eternally sustainable and stable.

Thus no government agency ever projects deep, long-lasting recessions, because such a period of stagnation would upend all the rosy projections that the status quo is eternally sustainable and stable.

Where does all this lead us? To this: Programs that backstop banks and social insurance systems like Medicare are not like fire or life insurance because they are effectively open-ended in terms of costs and in exposure to risk. A system which pools risk without distributing it to the participants and eliminates the causal connection between risk and consequence introduces moral hazard on a grand scale.

We'll discuss the systemic consequences of risk and moral hazard tomorrow in The Grand Experiment. 

Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

go to print edition1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

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To receive a 20% discount on the print edition: $19.20 (retail $24), follow the link, open a Createspace account and enter discount code SJRGPLAB. (This is the only way I can offer a discount.)

Thank you, Daniel E. ($4), for your most generous contribution to this site-- I am greatly honored by your support and readership.

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