Friday, January 8, 2010

risk management implies socialism not capitalism...

I've been hearing several stories on NPR recently that question the ideas of an unregulated free-market economy given the recent financial meltdown. The argument is that laissez-faire markets have been shown "not to work," there are now new doubts about whether markets are the most efficient system for managing resources.

Ok, so why is this disturbing? Because I think a critical distinction is being lost in the debate between free-markets and controlled economies. The critical distinction is a concept of risk.

Unregulated free markets work. They work well. They are extremely efficient. Nothing I've seen disproves that. However, they can be extraordinarily brutal -- usually when speculative bubbles pop. The free-market theory has been that less regulation will allow these bubbles to pop sooner and smaller -- but as recent experience has shown, that's not necessarily the case. A free-market's ideal is in information that represents actual value, but it's entirely possible for prolonged periods of speculation to exist and even grow, fueling such bubbles. When large bubbles pop, huge sections of the economy may be at risk. If this were allowed to happen, the results would be catastrophic, but they would ensure a quick demise to everyone who touched (and fueled) such speculation. This doesn't mean the concept of free-market is broken, or it's not efficient. It is cruelly efficient, but what we are really talking about is risk, not the free-market!

In fact, let me make a bold thesis: all forms of risk management move away from free-market capitalism towards socialism.

I'm not necessarily against socialism, but let's look closely at this new distinction that is absent from the current dialogue: if you embrace risk management, it means ultimately that you are diffusing risk to other areas, you are in effect damping all the wild fluctuations of the market into a smooth, level field. Hedge funds did this by intricately linking and amplifying thousands of previously unrelated investments. The bailout did this by spreading the losses over all American taxpayers. The extreme end of this arrow is zero-risk: zero development, zero capital, zero life. The extreme end of the free-market arrow is maximum-risk, which could be heaven or hell, or likely both over time.

The math of hedge funds and derivatives is fundamentally unstable - in every place it has been used, the results have been unpredictable and disastrous from the beginning of the very first hedge fund to use "zero-risk" maths, which lost billions of dollars in a few months. I believe this is because people are missing the connection between risk-management and socialist-economics. One implies the other automatically. This becomes painfully obvious if you look at the basic premise of hedge funds: to create zero-risk investment instruments... how is such a thing possible in a capitalist system which is built on risk? It would be like trying to build a casino where there is zero-risk... would you call it gambling?

Realistically, we will always have a mixed economy in some respects. The question is not whether one socio-economic system is better than another, it's how much do you want of one or the other. Or put simply, how much risk can we afford? I don't think zero-risk is necessarily a good place to aim, because we've seen exactly how that turns out.