charles hugh smith-The Grand Experiment: Offloading Risk onto the State

To understand the inevitability of systemic crisis, we must understand the nuanced narrative of risk in the modern world. We can start the story with the tremendous potential of real-world risk to change one's life dramatically for the worse.

Before the rise of insurance and government income-security programs, fortunes were lost when ships sank in storms, farms were lost to drought, and families plummeted into impoverishment when the primary wage earner died from accident or illness.

The pressing need to manage risk in the real world spawned the financial world. Mitigating the enormous risks of long-distance (and immensely profitable) maritime trade led to insurance, where the risk of losing the cargo was distributed to a pool of investors who earned a return for sharing the risk.

Risk management also led to the futures market, as cargoes were sold in advance to fund the extraordinarily costly voyages. This in turn led to financial markets and options trading, as these contracts were traded during the voyage. (Needless to say, speculators who bought contracts on overdue ships either lost their capital if the ship never returned or made fortunes if the ship managed to limp home, cargo intact.)

The joint stock company, where the risk is distributed to owners of shares, is not just a way to raise capital but a way to manage risk by distributing both profits and losses to voluntary participants.

All of these financial mechanisms were developed to manage natural-world risks. In a very real sense, risk has been offloaded from Nature to the economy, and specifically to the financial realm.

As noted yesterday, the key to understanding risk is to grasp that it cannot be managed out of existence, it can only be distributed to others, i.e. offloaded. The central illusion of finance is that risk can be magically reduced to near-zero. To repeat: risk can only be offloaded to others, either openly or by sleight of hand; it cannot be disappeared.

As societies struggled in the 19th century to manage both natural and financial risks, individuals and enterprises alike turned to the state (government) to manage risk. The natural world is intrinsically risky, but so is the world of finance, as mathematician Benoit Mandelbrot showed in his seminal book The (Mis)behavior of Markets: A Fractal View of Risk, Ruin And Reward.

One of Marx's contributions was to highlight the social and economic risks that are intrinsic to capitalism, which places a premium on dynamic flows of capital, labor and risk/return. Innovation and competition are inherently disruptive and risky, and this led to two developments:

1. State-cartel monopolies arose to eliminate competition that threatened their profits and power.

2. Private and state insurance programs arose to mitigate the risks inherent in Nature and capitalism.

1. Risks from the natural world were transferred to voluntary private insurance and financial markets;

2. This transferred risks inherent to Nature and capitalism to the financial sector of the economy;

3. Financial crises in the early 20th century led to financial risk being offloaded onto the state;

4. The risks intrinsic to capitalism and finance led to demands for pension and healthcare social insurance by the state.

Since risk cannot be eliminated, only offloaded to others, this transition of risk management from private to state has essentially concentrated risk into the state itself.

As I discussed yesterday in The Source of Systemic Crisis: Risk and Moral Hazard (August 21, 2013), social insurance programs such as Social Security and Medicare are not insurance in the sense of spreading risk of relatively rare, unpredictable losses (fire, ships sinking, etc.) to voluntary participants. They are more like life insurance in mitigating the inevitable, i.e. inability to work due to old age, death and illness.

The difference between social insurance and life insurance is the payout of life insurance is limited and known ($100,000 will be paid out when the insured passes away) while the payouts for social programs are essentially open-ended.

Insurance based on piling up contributions from participants into giant pools of capital that must earn market returns to fund disbursements are exposed to the risks intrinsic to capitalism and finance. The risks are not being spread to participants so much as transferred to the market. If the speculative bubbles in stocks, bonds and real estate collapse, all the pension plans based on investment returns (and that includes life insurance companies) will be exposed to enormous risks of insolvency.

In other words, pension plans based on sustained high rates of return from investments in intrinsically risky markets are at great risk of failure, as the plan's payouts are dependent not on distributing risk to all participants but on sustained high yields from intrinsically risky investments.

All pension and social welfare programs that are dependent on payroll taxes from wages are vulnerable to the "end of full-time work," which is simply the latest iteration in capitalism's dynamic process of innovation, creative destruction and constant change.

The dependence of pensions and social insurance programs on intrinsically risky markets and payrolls means the stability of these systems is illusory. The risk hasn't really been distributed to participants; the risk has been offloaded to those managing the pension funds in volatile markets and the state, which has accepted virtually all the systemic risks inherent to capitalism, Nature and finance.

The unspoken assumption is that the state can absorb essentially infinite risk because it can tap the earnings of a large pool of involuntary contributors (taxpayers) and borrow money to carry it through periods of slow growth or heavy losses.

The problem is the state's ability to tax/print/borrow money to cover payouts and losses is not infinite. Having transferred virtually all systemic risks to the state, we presume the state is so large and powerful that a virtually limitless amount of risk can be piled onto the state with no consequences.

Offloading risk onto the state does not make the risk vanish; it simply concentrates the risk of collapse into the state itself.

From the historical perspective, concentrating virtually all systemic risk into the state is a Grand Experiment. Cheap, abundant oil, expanding working-age populations and rapidly increasing productivity conjured the illusion that the state was large enough and powerful enough to absorb infinite risk with no real consequence.

As we shall discuss tomorrow, risk is near-infinite but the state's ability to conjure/borrow money is not infinite. Once a built-in financial limit is reached, the risks concentrated into the state collapse the state itself.

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:

1. 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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