When Risk Is Disconnected From Consequence, The System Itself Is At Risk

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.

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