The Risks of Failure
May. 6th, 2008 12:27 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
rowynEncouraging 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?
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?
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no subject
Date: 2008-05-06 05:48 pm (UTC)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).
no subject
Date: 2008-05-06 06:02 pm (UTC)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.