21st Century Risk and Danger

It seems inevitable that any system set up to deal with risk in the end becomes a source of danger. Or risk. Or danger. What’s the difference? Does it matter? I offer two cases - finance and welfare.

1. Financial market innovations in insurance, banking products, futures, stock exchanges, securitisation, derivatives, and government bonds, which played starring roles during the 21st century financial crisis, emerged as innovations to tame someone’s risk and turn personal risk into collective safety-in-numbers. It is not the first time that products designed to hedge against financial risk have subsequently been directly implicated in panics, market meltdowns, and depressions (the breakthrough financial innovations date back to the nineteenth century). New technologies augmented the velocities and geographic spread. It is reasonable to expect the same markets to develop new financial products and processes that will attempt future improvements in risk management ... until, once again, the innovation bandwagon turns dangerous. It almost always does. Predictability.

Support Project Syndicate’s mission

Project Syndicate needs your help to provide readers everywhere equal access to the ideas and debates shaping their lives.

Learn more

2. The largest risk management system ever devised -- state welfare, or social security -- was, until its costs and incentives became problems, a successful collective insurance enterprise based on a fiscal ‘social contract’. It was almost universally believed to be a genuine “free lunch”, until fiscal rivers began to run dry. Given that public debts and deficits which by now paid for state welfare were the critical vulnerability of wealthy countries on the eve of crisis, and given that welfare dependence or rights shaped political coalitions and reduced the flexibility of societies in recovery, it is clear that state welfare and financial products were flip sides of the exact same risk coin. Sovereigns rushed to rescue citizens and banks from financial collapse and then shamefully realised their own financial collapse was imminent. Quicksand is a perilous place from which to launch rescue missions.

The most sociologically acceptable general definition of risk is one which depicts risk as the counterpoint to danger. Both require uncertainty. A risk is always a decision to control the negative outcome. A danger is always a future potential loss resulting from an uncontrollable external factor. The first can be calculated. As for the second, you never know when it will surprise you. Risk is goal oriented agency. Danger happens. In both examples 1 and 2 some preexisting dangers were successfully transformed into risks, but subsequent decisions turned the risks back into danger. In fact, modernisation and technology may be no more than an intensification of this loop. It won’t go away.

There is some parallel with the ‘internal’ and ‘external’ factors of economic depression I looked at last week. Motives that characterise risk inside the economic mechanism (entrepreneurship, innovation, competition) involve normal decisions, intentions to control outcomes, and eventually produce breakdowns. The danger outside (social, political, international) is a specific factor that helps make each time different.

This simple risk-and-danger distinction becomes really interesting when you see that one person’s risk is another person’s danger. Financial firms make decisions about insurance policies, bank products, or investment vehicles that may have similar entrepreneurial motives (creating supply and meeting demand). When they go belly up they pose a danger to populations, including the people who may or not have bought and benefited from the products but were never participants in the calculations of risk. Very similarly, politicians and bureaucrats make decisions about social spending on welfare and social security products that have political motives (creating supply and meeting demand). When they go belly up … OK you already know the story, the same happens as in the first example.

In both cases the decision makers might believe they are helping to eliminate systemic dangers, but the unintended consequence is that they have created systemic dangers.

The risk and dangers of privately produced fancy financial products have been known for over a century. The risks and dangers of dull publicly produced welfare products are new on the scene. This is the first major crisis of capitalism in which collective economic vulnerability was tied up with financial and incentive effects of state social spending.

Assume that financial and welfare products are both equally desirable, but that -- as a logical consequence of the crisis -- there will be regulatory and political reforms that restore their sustainability. In neither case, however, would anybody seriously predict that the risks and dangers of financial and welfare sectors will be made to go away for ever and ever. Assume, therefore, that financial and welfare risks and dangers are here to stay.

What can be done? The missing factor lies on the side of the danger victims, the living units of society, i.e. the individuals who bear the brunt of the known-unknowns: collective dangers. What needs to happen, one might well argue, is for individuals to ‘occupy’ risk, or own their risk. They too must make prudential decisions to protect themselves; they must ‘take back’ part of their risk space from financial markets and political markets for welfare. Government can nudge them to do it, or can remind them to go-nudge-yourself.

Stoicism is part of the insight. A year ago, 7th June 2012 to be precise, I tweeted Seneca:
Seneca: "Men's bodies are better fitted for warfare if they can be compressed into their armour than if they bulge out of it"
Seneca: "Seek a safe harbour from time to time as if you were on a dangerous voyage"
Seneca: "When ordered to repay his debt the wise man will not complain but will say thank you for what I possessed and held"
Seneca: The wise man "regards as held on sufferance his possessions status, even his body eyes and hand, as though he were lent to himself"

Be like the old mariners who, even after they began to buy commercial marine insurance, still aimed to stay alive by regularly seeking safe harbours. Don’t let yourself get fat. Don’t take your possessions for granted. Respect debt because it is not your possession. Seneca said, wherever you may be, never assume there is no danger of earthquakes. Live well by preparing any minute to fall sick or die. Beware: “Look at the way the waves roll onto the beaches; the oceans are trained in how to flood the earth”. Joseph Schumpeter’s ‘long wave’ theory of economic fluctuation can be a similar lesson to be stoic about the inevitable and recurrent crises of the capitalism; the capitalism that enabled each small part of the peace and prosperity we are so privileged to enjoy in advanced economies.

There is one other option. Collectively we could decide that economic risk and danger are unethical and immoral. By banning them we will ban capitalism too. Hooray. Oh wait, that might be risky. Plus, if you do that to me I could say you put me in danger. Because everything is complex, maybe we should be stoic together. We must occupy Risk Street, make some simple but important decisions, and quietly accept the consequences.