The Risks of Failure

[rowyn]

Encouraging risk-taking is a big part of American society. It's one of the reasons that capitalism works: it encourages risk-taking by offering big individual rewards for success. Pure communism discourages risk-taking by offering very little reward for success (perhaps fame or some trickle-down benefit gaiined from helping everyone, but no jackpots).

The flip side of the reward for success is the cost of failure. A high penalty for failure discourages risk-taking. This is, to a degree, good, because you want to discourage people from taking stupid risks. But if the penalties are too severe, then otherwise good bets will start to look bad. For example, let's say I want to invest money in an idea that I believe has a 75% chance of returning 200% on my investment, and a 25% chance of losing everything. From a pure-math standpoint, this is a rational risk. My average return would be 125% of my investment: clearly right.

But let's say that I need $1,000 to invest, and that this is my rent money and I'll be evicted if I lose it. Suddenly, the total price of failure is significantly higher. It still might be right to invest, but I'm going to be much less happy about it if I lose.

Now let's say I need $10,000 to invest, and the only way I can get it is by borrowing money that I won't be ably to pay back if I lose on the investment. Let's assume I'm facing both eviction and bankruptcy if I lose now. That extra $20,000 3/4ths of the time isn't looking so great compared to financial ruin 1/4th of the time.

As a last example: imagine that there are no bankruptcy laws and America has debtor's prison instead, with jail sentences of two months for every $1000. In this instance, borrowing the money to invest it in something so risky would be wholly irrational if not outright insanity.

In my ideal world, I think I want this investment to look, roughly, about as attractive whether I have to borrow the money to invest it or not. I don't want it to look more attractive if I'm borrowing the money (because it's not "my" money) but I don't want it to look markedly less attractive, either (because of horrific penalities for failure to repay). It's a good risk: I want to encourage people to take it.

By contrast, I do not want my ideal world to encourage people to take bad risks. A program that said "you can claim as a tax credit any losses on investments" would be horrible, because that would make otherwise stupid risks rational. A scenario where there's a 95% chance of total loss and a 5% chance of doubling the investment would suddenly become mathematically right, because the government would be covering my losses 95% of the time and I still get to keep my gains the 5% that it works out. This is bad.

I'm a libertarian in part because I believe that government intervention far more often encourages bad risks than good ones. For example, I don't like the idea of a government bailout of any of the parties (lenders, borrowers, or investors) to the real estate market meltdown, because these are all people who engaged in risky behavior that would have profited them greatly had it worked out. It did not work out, and ameliorating that risk for them means encouraging them and others after them to take similar poor risks and expect a government bailout.

But as I think of the distinction between "debtor's prison" and "bankruptcy", I wonder if there are other ways in which law could encourage responsible risk-taking. What could the government do to help people to take good risks without making bad risks attractive?

Comments

[level-head.livejournal.com]

Litigation is the risk of success, unfortunately, and is all-too-common.

On the mortgage aspects: for the huge majority, it has been tremendously successful. And the Fed loan guidelines did a lot to encourage the sort of risky loans that were part of the problem. I'm not in favor of bailouts, but I'm not in favor of the original interference with the market that contributed to the need for bailouts either.

In my opinion, litigation reform would be the largest single factor to encourage entrepreneurship in the US again, followed by less confiscatory taxes on success.

Each of these would increase government tax revenues; the combination would be extraordinarily rich for revenue collection. (Spending caps must be in place if we're ever going to see a reduction in the deficit.)

The litigation reduces the risk of success, while at the same time reducing the incentives for the large number of people that pursue such litigation as their own "success" strategy. We currently have millions of people motivated to cause others to fail or lose money.

===|==============/ Level Head

[rowyn]

Mmm, yes. Litigation serves a valuable role in discouraging stupid risks. But our jackpot-litagation system (especially with class-action suits) goes much too far in discouraging any kind of risk.

[level-head.livejournal.com]

A large new problem in California is the "conceivable harm" test. A private individual -- an attorney not connected with any government -- can bring a multi-million-dollar action against a businessperson for something that the attorney alleges could "conceivably" cause harm, even though no actual harm or damages have ever occurred.

It is always possible to allege conceivable harm. One small businessperson I know (employing mostly his family) was destroyed by a "conceivable harm" suit for sixty million dollars, hundreds of times his revenue. And the allegations were simply wrong.

Their business was doing well, after years of hard work. Then they came to the attention of an attorney.

They lost everything.

===|==============/ Level Head

[shockwave77598.livejournal.com]

Time to move the business out of California, then.

Yeah, I hear you. I was asked once to design a sensor that would beep when a street light change from Red to Green for a gent who was colorblind. Arguments that all lights are red on top or on the right didn't matter. I had to pass on the request. It was technically easy to build. But if he got into a wreck, I would be sued into oblivian. It would not matter if he had it in his trunk. It would not matter if he was Tboned on a straight road and the next traffic light was 30 miles away. Everyone within 10 miles of the wreck would sue me for causing "Pain and Suffering".

Beats me how anyone can make and sell a lawnmower anymore.

[koogrr.livejournal.com]

Well you know the jokes:

What's the Canadian dream? Making it big in the US.
What's the American dream? Suing someone and making it big.

[rowyn]

Y'know, I actually hadn't heard those before.

The Canadian one is sort of funny, probably because "the American Dream" is a catchphrase. The American one doesn't seem to work, though. Maybe it needs a build-up to lead to the punchline.

The Proclaimers have a song, "Everybody's a Victim", about blame and litigation. It includes the line "We're becoming like the USA".

To which I thought, "Hey! I resemble that remark."

[koogrr.livejournal.com]

The new American one might be: Sue someone and retire. That squirrel is kind of lost right now.

[terrycloth.livejournal.com]

I always sort of felt like Bankruptcy and Credit scores were supposed to work like:

Anyone can take *one* stupid risk. They might be ruined financially, but their debts can be forgiven and they can still have a life. Being ruined financially isn't a disaster like being put in prison would be.

But then your credit's trashed and no one will let you take a second stupid risk.

I'm not sure it actually works that way in practice, though... people get bankrupted for things that weren't their fault (medical problems, unemployment) and people who do take stupid risks can still find backing for more stupid risks later on somehow (I don't know how that works).

[rowyn]

If you talk to an actual loan officer at a bank, they'll be more forgiving of a credit score trashed by medical debts than one trashed for other reasons. Everyone knows the healthcare payment system in this country is a disaster.

Bankruptcy comes off of your credit report after, I think, seven years, so you can rebuild your credit. And get new chances to borrow money you can't possibly repay. Also, some lenders will lend to people with horrible credit and cover the additional risk with big fees and high interest rates. But I don't think this is a problem with the system: banks and individuals both should have the right to do dumb things with their money.

So I think it's less that you only get one chance as that it will get increasingly more costly to take additional ones. Which I'm okay with; it's not a great system but I can't think of a better practical alternative.

[shockwave77598.livejournal.com]

While I agree in principle, in real world, the wealthy won't give up their gains, ever. If they can protect 1/2 their profits by closing the businesses down and putting the world in a depression, then that's what they'll do. Perfect sense in their minds, just like cutting back expenses in lean years is perfect sense in ours. The only ones powerful enough to rein in the wealthy are the lawmakers, who sadly are in the pockets of the wealthy and won't do anything.

What irks me is that none of this would have come about if regulations previously in place had been left in place. But predatory companies have sold politicians on the lie that Regulation is Bad, mkay. So now instead of regulations squelching the ability to make money, we have Zaibatsus running little businesses under their wheels and charging anything they wish for whatever they wish. And then when the bubble can't withstand their abuses anymore, they want a bailout. Sorry, but a bailout will come with a) reregulation, and b) demand for payback within the next 10 years.

You cannot get rid of government regulation and taxation one minute and then beg for a handout from the very same government the next. That's gross hypocrisy and should be spelled out as such. Then again, I believe corporate criminals should be shown on America's Most Wanted - I'm a radical.

[rowyn]

I reeeeeally don't want to bail any of them out. As for regulation, well, depends what the regs say. Some regulations are reasonable and some are appalling, doing more harm than good.

well done

[(Anonymous)]

thank you, brother