The problem so much of this country faces can be sourced back to one common practice that many of us cannot bring ourselves to face. Unrealistic promises. The world is full of risks, in fact life could be described as nothing but a massive risk management exercise. Will my paychecks be enough to cover my bills this month? Will I have any unexpected expenses this month? Will a plane fall out of the sky on to me? Will my business be adversely affected by Obamacare? Will the price of oil rise so high I can’t afford my commute? Will the value of stocks, bonds, gold, land, or whatever I use to hold and grow value over time crash? Will those investments go through the roof and I will have missed the opportunity to invest more?
Many people in business spend a lot of time trying to quantify and figure out manage risks but the important thing to remember is that risk never goes away. It can be diced up, spread around, shared, concentrated, traded, bought, and sold but it never goes away. Just because you bought an insurance policy or a derivative to offset your risk doesn’t mean the risk went away. You just replaced it with a different risk. You got rid your basic risk and replaced it with the risk the insurer or derivative originator won’t be able to pay out according to the policy or contract. You had better know how much in reserve your partner has to cover these risks and what their total exposure is. AIG sold contracts with 72 trillion dollars’ worth of exposure with almost no reserves and zero visibility to their clients or regulators. Let’s put that in perspective, global economic output in 2011 was just under 70 trillion dollars. Lesson learned should be lack of regulation may allow for business innovation but that innovation may not be good thing for the unwise. Always know your business partners. Don’t accept what they say on its face. Dig deep, analyze, if they have a problem disclosing information you need to be a wise investor, walk away.
That’s not to say that risk is a bad thing. Risk is simply a fact of life. Let’s define risk. Risk can be defined as a noun meaning “a situation involving exposure to danger” or as a verb meaning “expose to danger, harm, or loss” Taking risks can result in a reward if the expectations are met or exceeded but result in loss if expectations are not met. In business we often express risk in terms of probability such as 1/3 chance upside risk outcome, 1/3 chance of expected outcome, and 1/3 chance of downside outcome. Equations are developed for each of these three scenarios and a weighted outcome is calculated usually expressed as a return on investment.
Strangely one of the best expressions of the benefits of risk was not expressed by a capitalist but a communist and not just anyone but The Communist Karl Marx. He advocated that the flaw in Capitalism was that in any capitalist endeavor workers must be paid less than what the contributed to the bottom line in order for the Capitalist (entrepreneur or investor in modern usage) to make a profit. By this definition even athletes or actors making millions of dollars per year are “exploited” because their employer is still making money. By Marx’s definition only co-ops and not for profit organizations could ever be considered non-exploitive. What Marx didn’t understand is this is the ultimate thing right about Capitalism. Business owners put their capital on the line when they start the business, when they take a premium on what the workers contribute to the organization they are reaping the reward from their risk.
The worker on the other hand is taking a discount on what his labor is truly worth because he is not taking as much risk. He is the first one paid if a business fails, is usually paid sooner and more often than vendors, and he does not invest his own capital. The employee is not without any risk as his employment is not guaranteed nor is his wages fixed. These all have to be determined by supply and demand in a free and open market place. Just as consumers and suppliers must assign a value to the utility they get from a purchase, employees and employers must assign values to the time, effort, and wages exchanged in the labor market. Both sides must be free to change those values as their needs change.
Many conservatives express a lot of anger at unions for the contracts they sign with management. Some of the worst of these contracts promise unrealistic continuation of benefits such as minimum number of workers, fixed wage rates, and benefits regardless of the financial health of the organization. The thing to remember here is that management agreed to this. They agreed to offload all the risk of the employee and take it on themselves. Lots of reasons for this come to mind but the simplest are that times were good and they were short sighted enough to believe good times would last longer than the contract. This is one of those unrealistic promises people make. Simply put even unions shouldn’t seek contracts that promise too much for too long with too little flexibility. The company just won’t be able to keep their unrealistic promises.
A second form of unrealistic promise we buy into are pensions. Pensions are usually classified as guaranteed benefit or guaranteed contribution. Let’s look at the guaranteed benefit first. Everyone needs a certain amount of money to stop working and retire. Hence we have a risk situation: upside we have more money than needed to retire, expected situation we have enough to retire, and downside we have too little to retire. In a defined benefit plan, the company promises to provide a certain level of retirement income based on some formula usually centered on your wages. They calculated the amount of money they will need at your retirement time. Then they discount this (the opposite of compounding interest) by some interest rate back to today’s dollars to determine how much they need to fund in the current period so that investment can grow until you reach retirement. The defined contribution plan varies because they instead guarantee they will contribute so much each year towards your retirement but do not guarantee how much in benefits you will get out of the plan at retirement. The main difference is who will accept the risk that the investment won’t grow according to plan. In a defined benefits plan if the rate of growth on the plan’s investments doesn’t meet or exceed the rate used to discount the amount needed to fund the benefits then the company must contribute more in the current period. In a defined contribution plan, the employee accepts the risk of the plan not having enough to fund their retirement. Currently most retirement plans are defined benefit plans but companies have made ridiculous assumptions about growth rates or other variables in the calculations to allow them to underfund these pensions. The lesson learned is to check what promises your company has made and see if they are making the contributions and using realistic calculations. If not don’t expect your retirement to be comfortable.
The way we chose to deal with many of our largest risks in the last century has largely been through government. “The problem is we have socialized risk and privatized reward.”-(Sen. Christopher Dodd) What do Social Security, Medicare, Medicaid, and virtually all other “entitlement” programs have in common? They all involve socializing risk and privatizing reward. This also includes tax breaks for specific industries, bail outs, and preferential regulations for specific industries. “We the people” are expected to bear the burden to make sure private citizens and corporations get to succeed regardless of what risks they took but they got to keep the rewards of taking those risks. Government has told the poor “you can’t afford healthcare?” That’s okay, we will take care of that. Didn’t save enough for retirement? We got your back. You don’t produce an airplane anyone wants to buy? Don’t worry we’ll lease them for more than what you want to sell them for. Your competitor makes more than you? We’ll agree to additional regulations that benefit you! (Most regulations don’t come out of thin air or from citizen special interests, they come from rival businesses or industries seeking to straddle rivals with additional costs. If you don’t believe me, then look at who pays the lobbyists.)
The worst part of this is that many of these programs are essentially defined benefit programs. Congress, in their infinite wisdom, wrote the laws creating Social Security, Medicare, and Medicaid as guaranteeing benefits rather than levels of funding. Hence it isn’t as simple as they stop cutting checks to the beneficiaries. Those beneficiaries are legally entitled to those benefits and if the US Treasury doesn’t fund them then it will just turn into a huge legal mess with the Supreme Court eventually citing the 14th amendment not allowing the government to repudiate its debts.
Reforming the programs to fit our current funding the is simplest fix but trying to cut these programs down to size is politically unlikely as most benefit senior citizens who reliably vote as a block against any attempt to cut their benefits. Requiring a balanced budget might work. Since these programs often require funding this would force massive tax increases. That might produce consensus on how to reform these programs but would rob the government of short term funding needed for things like fighting wars or dealing with a large crisis. No solution is easy or someone would have already implemented it.
Another important thing to think about is that people bought into these promises and are depending on them. If you think a Crunch is coming, then think about the situation if Medicare, Medicaid, and Social Security suddenly ended (this is essentially what would have to happen to balance our federal budget). How many people would die? How many elderly would starve as their only source of income dried up? How many children would go without any sort of medical care? How many elderly would die without their medications?
We can say that this should be left up to private charity but lack of private charity is what led to Federal Government taking up these obligations that are now strangling the country! Remember Christ commanded love of your neighbor. Ayn Rand extolled reason over faith and self over others. Gordon Gecko said “Greed, for lack of a better word, is good”. Christ said “…You cannot serve both God and money.” (Mathew 6:24).
Simply put, we can’t continue to make unrealistic promises and not deal with the risks of life. It leads down a path of self-deception and folly. We have to find ways to make this world hospitable to all in a way that doesn’t destroy our urge to better ourselves.