Tuesday, 15 May 2012

Risk taking is a necessity.

The prestigious American Economist Allan H. Meltzer once said that "Capitalism without failure is like religion without sin. It doesn't work". 

Anyone who believes in Capitalism will agree that individuals and corporation need to fail. If we are to create a healthy and competitive market place that is able to bring the maximum possible degree of development and progress for all, we need to allow bad companies, ideas or strategies to fail in order to give way to better and more efficient ones. However, it is not only absolute failure (e.g. bankruptcy and liquidation) what Capitalism need. A healthy form of Capitalism also needs to allow market players to make mistakes. There is no doubt that mistakes are good for Capitalism in two ways: first, they allow market players to learn and therefore is an optimal way of improving performance; and, second, if we are to commit the same (or different) mistakes repeatedly, it will more likely lead to an ultimate failure of inefficient propositions.

However, “failure” is just the consequence. The cause is “risk”. If we fail in our objectives, or if we achieve them, the reason will be that, at some point, we have decided to take a particular course of action without knowing for certain what the result will be. In other words, we have taken some degree of “risk”. For example, when Christopher Columbus set off for the East Indies, he took a risk. So did the Catholic Kings of Spain who funded the expedition. And certainly, so do companies in every decision they take. Therefore, risk is an essential human necessity to achieve success, although it has a negative downside: “failure”.

Yet, it seems that some financial commentators and politicians are unable to grasp this elemental fact. And accordingly, when JP Morgan announced last Thursday that it had a $2 billion loss from a trade going sour in its Chief Investment Office in London, they seemed to have been taken aback by the fact that the bank was taking a risk and are now decided to push forward a change to the regulatory framework so that it cannot happen again. 

Individuals and companies have an intrinsic incentive to control the risk they take if the are to achieve success instead of failure. Yet, this incentive can be distorted (read here anti free markets policies such as government support of failed institutions) and hence there still may be a case to promote rules that will protect unconnected third parties, such as taxpayers or clients of the institution, when everything goes awfully wrong. Nonetheless, if we are to cultivate an advanced and developed society, individuals and companies should be allowed to take risks, and hence fail, or make mistakes regardless of how painful the can be for the maker. Responsibility for the decision taken and its consequences (failure or success) are a key element of capitalism that regulators and politicians should always bear in mind. For that reason, law-makers and regulators should abstain from pushing through politically driven and impulsive regulation and simply ensure that any rules protect innocent third parties while permitting companies and individuals to take risk.

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