America’s wars have become increasingly abstract. First we fought the British. Then we fought ourselves. Then the Germans. Then the Germans and Japanese. Then the Koreans and Vietnamese. Somewhere along the way we found non-human enemies. We started fighting drugs. At least that was still alive, albeit in the vegetable kingdom. But then we declared war on poverty, an economic condition. Then terror, a contingent emotion. Now we have declared our final war against risk itself.

If we win this war, then we will have won all wars. No enemy would be able to take us by surprise. Terror would be a thing of the past, generating academic curiosity and smug contempt, much like slavery does now. We will shake our heads and wonder how people could possibly have lived like that when there was this better way.

Illegal drug use would be out of the question and all approved drugs would have no random side effects. Life would be nice and steady. Our economy would grow at a constant two percent per year. The options markets would be shut down and the stock market would be replaced with a chalkboard since all stock prices would merely grow at the same rate as the economy. 

We would never have another bubble, in any assets, ever again. We would never have any car accidents or delayed flights or natural disasters. We would have tamed risk, and the universe itself. Electrons would no longer randomly and bizarrely live in a probabilistic world: Heisenberg’s uncertainty principle would be outlawed and we would know the exact position and momentum of every single particle in the universe.

Innovation and creativity do not have to wither and die. They could be managed and expected. It sounds like fantasy but it is not really that outlandish. Creative people constantly develop brand new ideas on a deadline. We will, as a society, plan our future inventions. The patent office would be able to predict future products and issue pre-emptive patents. Most importantly, financial crises will be a thing of the past. 

Last week, President Obama launched the opening salvo in our new war against risk with a specific, 89-page description of financial reform. Financial firms would be more regulated so they could never again fail. Financial markets would be more transparent so they could never again cause losses. Consumers and investors would have government protection. The government would have a broad range of new powers, of course, because after all, this is war. And the international community would be organized into a community with a common enemy: the unknown.

Obama praised his own proposal as being “by all accounts… a commonsense, reasonable, non-ideological approach.” 

Well, he was already wrong on one thing. It is not "by all accounts." Hi there! I disagree.

My father and I recently proved in a research article  that any regulation of risk actually increases risk. Moreover, any objective regulatory algorithm to measure and manage risk capital will always result in independent banks simultaneously choosing to invest in securities that appear to be low risk based on the particular algorithm, but which in fact have higher risk. We proved this both mathematically and empirically, and it holds for any regulation where the measure of risk is objective. In other words, Obama’s proposal is doomed to fail. What’s worse is that the introduction of new regulations will only increase the probability and severity of future financial crises. 

Does that mean we are doomed to a life of chaos? That risk itself has won?

There are two ways out of the risk-increasing regulatory morass, and they both work by making risk management a subjective rather than an objective process. One way is to fully nationalize all financial firms. We can then just focus on finding good quality regulators to run them. They will be able to make subjective decisions about each bank’s portfolio and lending decisions without the handcuffs of an objective rule. Perhaps this is Obama’s ultimate goal. But of course then risk does not disappear but merely lie in wait as economic and financial decisions get made for political purposes, and any tiny loss can become a collapse of the entire system, since they are all integrated.

The only other possible solution is a complete deregulation of all financial entities. That would mean shutting down the Federal Reserve, America’s central bank. It would also mean ending the FDIC, federal deposit insurance. When you put money in a bank, you would have to be confident in that bank, just like when you invest money in a stock, you have to be confident in that stock. After all, a bank is nothing more than a company that takes your money, hands out long term loans, and tries repay you on demand. 

This is not as radical as it seems. Indeed, perhaps counterintuitively, allowing risk to reign free would reduce risk. In a free market, when a bank fails, only that bank fails, and at worst a handful of others who depended on it to their detriment. The system remains. The possibility of a financial crisis lessens. 

We have tried the approach that has been billed as commonsense and middle-of-the-road. We may disagree whether we should veer off the cliff to full nationalization or pull over to complete deregulation, but one thing is clear: when you are fighting against risk, the one place you don’t want to be left standing is in the middle of the road.

phil@maymin.com