Risk Transfer

I have stated before that I think the definition of civilization is the reduction of risk. The recent history of risk is quite interesting, especially as it relates to power in society and economics.

The Capital Asset Pricing Model of the early 1960s was a major step forward in the world of finance, allowing people to price assets while taking risk into account. Once this became socialized, largely through MBA programs, businesses had a useful tool to assist them in creating financial portfolios.

As an example of what could be done, consider a retail company. They pull in a huge amount of cash at Christmas time; if they are at all good at managing their supply, they won't pay that out until well into the folowing year. So they sit on a huge pile of money for several months, and they want, obviously, to get some return on that. They could put it all in a high-flying tech stock, but risk losing a good portion of it. They could put it in a bank CD, but get a lower return than necessary.

What they do is hire an MBA as CFO, someone who through modern portfolio management techniques can generate a safe and certain return. It will be more than the CD, and the risk will be managed virtually out of the cash.

A company like Wal-Mart has other ways of managing risk, largely due to their size. Their vaunted supply chain techniques, in which they sign hardball contracts with their suppliers, allows them to know quite accurately what their cost of goods will be, regardless of commodity price changes.

But these successes in managing risk proved very seductive to the people in charge. If you can manage financial risk and commodity risk, why can't you manage away every other sort of risk? How, then, can you create a company in which all risk factors are as close to 0 as possible?

The easiest way is to find methods of transferring the risk to others. This is similar to the way that farmers use the commodity exchanges to reduce their risk, by signing contracts to sell their goods at a future price - these contracts are put into the commodity market system where they are bought and sold. In other words, people who are willing to play the game can, while the farmer guarantees return for the year (I know I'm disregarding the supply risk to the farmer, whether from drought or pests, but that seems unavoidable except through technology).

Gambling works the same way. Those who are willing to take on risk, the players, who do so for entertainment value (and at least some hope of an unrealistic return), accept it, while the risk-averse casino owners (or lottery operators, etc.) make a steady profit.

Let's take a simple look at how business worked before, say, the 1980s. The entrepreneur took on the risk of starting a company; at some point the risk was shared by taking the company public, so stockholders assumed the risk; and some of the risk, a fairly small amount, was taken by customers and suppliers (though that risk was mitigated by various laws regulating business).

There was no sense that employees should have any particular risk for working at the company, other than occupational hazards (again mitigated by workplace safety laws) and some risk of job loss if the company went out of business.

Over the years, some companies would reduce their risk by shifting it to other entities. For example, some businesses would release toxins into the environment. They wouldn't have to deal with the cost, others would. Then came the EPA to assure the neighbors of factories and plants that they would not have to risk their health just because they lived downwind.

All of these risk-reducing laws and regualtions, laws concerning fraud, breach of contract, workplace safety, environmental regard, were seen by most people as a good thing. The occasional libertarian or business advocacy group would come along, point to a few cases where the regulators over-reached (sometimes hilariously - who remembers the publicized OSHA ladder regualtions?), and argue that business was being strangled.

Few people took any of this seriously. That someone, generally government, was looking out for the "little guy," was considered a mark of an improving society.

Then came Ronald, "The Great Communicator", "Government is bad," Reagan. His election in 1980 represented a major philosophical shift in the relationship citizens had to the government. This was the point at which risk became, not something to be reduced through collective action, but an unacceptable drag on the prosperity of the nation if assumed by corporations and government.

But the risk didn't disappear just because we refused to acknowledge it. Getting rid of workplace regulations didn't lower the risk of accident or dismemberment, it pushed it back on to the employees. A company that wanted to open a new plant didn't have to put up the money for it if they could talk government into financing it.

In fact, risk is pretty much constant in the short term. Oh, there are times when a medical or technological breakthrough might create a major jump in the reduction of risk. For the most part, though, risk is always there. The past 25 years has seen a major shift in risk from institutions to individuals.

If a company provides health insurance to its employees, it assumes the risk of rising costs. Now, every year brings a reduction in benefits, an increase in costs to the individual.

If a company guesses wrong on the next hot product, no problem, just lay off a few thousand employees, regardless of performance, and their bottom line will right itself.

If a company forgets how to make money in their industry, file for bankruptcy, blow away union contracts, destroy shareholder value, and emerge a leaner, stronger business, no matter how many people were hurt in the process.

The uneasiness that people feel right now, despite the so-called strong economy, results, I think, from the ever-increasing risk they are forced to take on. It isn't so much that corporate fat cats are well-compensated, it's that they are removing any possible risk from themselves (and their great-grandchildren) as they push it on the rest of us.

And it is unavoidable. There is no class you can take, no field of study, no industry you can get into that will insulate you from the uncertainty. Any job that depends on education can be outsourced to the lowest bidder or offshored to the lowest-wage country. There is no safe haven, and the average person knows this, and grows restless.