The Diminution of Risk or How We Learned to Stop Worrying and Love Debt
Having suffered through more than a half-dozen economic traumas in my professional career, I had grown complacent and philosophical about economic cycles. That of course ended as we entered the latest recession and as one of the self employed I found myself more than inconvenienced, but one of the traumatized. Instead of focusing solely on the managing through the consequences of economic distress, I found myself in economic distress.
I still follow my advice to clients and keep pursuing new lines of business and creating opportunities for greater growth through the cycle. I have no doubt that as we enter recovery, my business will be far more profitable and larger. The returns will not translate into a higher standard of living, but only the ability to recover personal wealth for some years to come.
I am left with trying to understand what happened and to discern the fundamentals of the financial crisis. My conclusion is basic; financial stability is predicated on a fundamental relationship between risk and return and that relationship was nullified through misperception created by advanced risk transfer instruments. The creation of highly complex financial instruments designed to transfer risk have altered the perceived relationship between risk and return. Credit risk transfer through credit default swaps, collateralized debt obligations and a variety of other derivative products have blurred the risk return relationship. The fact of the matter is that while these instruments have transferred and dispersed risk, they cannot eliminate it.
What has happened is that the failure rate of individual obligations has overwhelmed the viability of the financial instruments designed to mitigate the risk. The larger problem is that personal, corporate and government behavior was influenced by the perceived lack of risk eliminating sound decision making that was traditionally tempered by the risk return relationship.
Public policy makers unfettered by traditional measures of risk made policy and influenced regulatory agencies in ways contrary to established norms to satisfy their desires to provide opportunities to individuals that were beyond their means and to allow corporate sponsors to grow beyond rational expectations. Corporations and individuals made similar irrational decisions intoxicated by the perceived lack of risk. The combined effect culminated in an overload of risk in the neatly packaged securities, insurance contracts and safety nets.
When the risk return relationship ceases to exist, greed runs amok in the capitalistic system. Greed drives the capitalist system. I do not mean that in the pejorative sense, but as the natural human behavior to want more and therefore, what is the foundation of the work ethic that has made capitalism the only viable model for modern economies.
Greed, as I define it, is kept in check by an understanding of the consequences of over-indulgence and if not that, limits placed on individuals, corporations and governments by their stakeholders. Greed and irrationality creates economic bubbles and ultimately the system collapses. The solution cannot be the banning of sophisticated financial instruments; that is impossible to control in any rational manner. Full disclosure of the use of the instruments and their inherent risks will create an environment of their prudent use and rational decision making that may prevent the unsophisticated from becoming victims of their own ignorance and greed. The melt down cannot be blamed on any one group of individuals; it was the collective failure of society to recognize the consequences of their own actions or maybe fluoridation.
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