When Risk Is Separated From Gain, The System Is Doomed

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

If the gambler has no feedback from his bets because the casino reimburses his losses, then he will continue gambling wildly and losing spectacularly.

Risk is an ever-present characteristic of life; it cannot be eliminated, it can only be masked or hedged. We know this intuitively, yet we blithely accept official assurances that risk can be eliminated by the monetary machinations of the Federal Reserve, the Central Bank of China, the Bank of Japan and the European Central Bank.

To confuse masking risk with the elimination of risk is the acme of hubris and the perfect setup for disaster. In my view, the global central bank response has been directed at masking risk and presenting this as the "solution" that has sent risk back to its lair, defeated. But cloaking risk does not eliminate it; official obfuscation merely pushes risk beneath the surface where it accumulates unseen.

Once the built-up risk reaches criticality, it explodes in "unforeseen" volatility that is often triggered by a seemingly unimportant event.

One way that risk is systemically and deliberately hidden is by separating it from the gain or loss that results from taking the risk. This is also called "moral hazard," and the example everyone now knows is private banks that "privatized profits and socialized losses" by keeping their outsized profits skimmed in the go-go years and transferring their staggering losses to the public ledger.

From the point of view of risk analysis, the risk of losses from malinvestment and speculation were separated from the gains. The banks kept the gains but then diverted the losses (risk) to the taxpayers via the $14 trillion TARP bailout and $16 trillion in "secret" subsidies and give-aways only revealed by a FOIA release of 30,000 pages won by Bloomberg.

We can understand this disconnect as the severing of the feedback loop from risk to gain. If the gambler has no feedback from his bets because the casino reimburses his losses, then he will continue gambling wildly and losing spectaularly. After all, why not?

This explains why the Fed and the Obama administration will not just fail, but fail spectacularly: not only are they individually distant from the risks incurred by their policies, those entities they are protecting (the banking sector, the higher education cartel, sickcare, etc.) are also protected from risk.
Without feedback (we might also call it the possibility of loss or defeat), the players and the system are both intrinsically doomed to failure. There is no other end-state possible if you start from this initial condition.

Thanks to globe-trotting correspondent Toby B., who sent me the book and several other fascinating histories, I have read a deeply insightful history of the pivotal battle of Midway, June 1942: Shattered Sword: The Untold Story of the Battle of Midway.

The book is unique among war histories in that it explores the culture and internal conflicts of the Japanese Imperial Navy which contributed (as initial conditions) to the unexpected defeat at Midway by the inferior forces of the American Navy.

Having studied Japanese history, language, geography and literature in university, the culture of the Imperial Navy was not entirely new ground. But the internal conflicts over differing strategies in the Japanese central command and Imperial Navy were new and of great interest, for they reflected not just Japanese culture but (not unexpectedly) human nature.

Japan's remarkably decisive successes in the first months of the Pacific war left the high command with the unusual problem of "what do we do next?" Having achieved all their tactical goals, debates raged over what to attempt next.

Admiral Yamamoto, the chief architect (though by no means uncontested) of Japan's strategy, opted to draw out America's aircraft carriers into a "decisive battle"--the heart of Japanese Naval doctrine. He devised the Midway campaign to do exactly this.

After such an amazing string of victories over the American, Dutch and British navies following Pearl Harbor, the idea of defeat did not enter the computations or the debates, nor did the idea that all the various strategies proposed were highly risky.

The denial and disorientation caused by the catastrophic loss of Japan's four finest aircraft carriers in a single day did not deter the Japanese commanders from pressing on to Midway; their mindset did not allow for defeat, and so they had no choice but to press on to victory.

Eventually Admiral Yamamoto conceded the campaign had failed to reach its objectives--destroy the U.S. aircraft carriers and capture Midway Island, and that pressing on would only endanger what was left of the Japanese fleet.

All of this struck me as absolutely telling in regards to the Fed's campaign to restart the U.S. economy by lowering interest rates to zero and flooding the system with free, cheap money (liquidity). The strategy is simple: drive the cost of borrowing money so low that people will once again buy homes with 3% down payments and huge mortgages, and plow their money into the stock market, the asset class (along with real estate) which is inflated monthly as an official Fed policy.

This is the Fed's strategy: drive "risk assets" like stocks up until some magical point is reached and households feel wealthy and confident again, and start borrowing and spending with abandon. The fact that only 10% of U.S. households own enough stock to expereince this "wealth effect" simply doesn't register in the Fed's mindset: risk has been eliminated and thus victory is assured.

The idea that this strategy is flawed does not occur to the Fed leadership; this mindset is so narrow and atrophied that the Fed has no alternative but to "press on to victory," even as the ship is sinking beneath them.
The same can be said of President Obama, who appears unable to grasp that his policies have been catastrophically misguided.

I suspect 2014 will be the year--after five long years of the same battle plan--that the total and complete failure of this strategy will be revealed to all. The Fed and Obama administration are steaming their flagships toward the booming guns on the horizon, confident of victory even as the undetected squadrons of risk are high above, setting their bombsites on the foaming white wakes of hubris below.

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fonzannoon's picture

I suspect 2010, 2011, 2012, 2013, 2014 will be the year--after _ long years of the same battle plan--that the total and complete failure of this strategy will be revealed to all. 


Give me a break with this.....

IdeasRbulletproof's picture

And every time I say it can't get any worse than this...

Chris Jusset's picture

CHS says:

Once the built-up risk reaches criticality, it explodes in "unforeseen" volatility that is often triggered by a seemingly unimportant event.

So who can guess what this "seemingly unimportant event" will be?  ZH should have a contest to see who comes the closest to guessing what seemingly minor event will trigger the ultimate collapse of this hellish house-of-cards.

TheTmfreak's picture

I read the title while browsing the headlines, and said "let me guess, charles hugh smith". Turns out I was right...

NoDebt's picture

It's not over yet.  We haven't finished gutting the middle class.  I'd say we're about 50% of the way there.  Once there's no more middle class, then it will fail (and by fail I mean it will be deemed a success).

Dick Buttkiss's picture

Not only do I think he's right; I very much hope he's right, for the simple reason that the longer the next stock market crash is delayed, the worse the overall damage will be. There's no growing our way out of a $200 trillion, and counting, fiscal gap — http://www.zerohedge.com/news/2013-09-11/lawrence-kotlikoff-us-fiscal-ga... — especially when what growth there is comes at the cost of rapidly diminishing returns on the debt needed to create it.

So if you haven't already, prepare yourself now:


TMLutas's picture

While you're right that the longer this goes on the worse the damage is, I don't think he's right that 2014 will be the year that things come to a head. It might happen but the odds are that the MSM will retain enough credibility to paper things over one more year. 

BoNeSxxx's picture

I am with you there Fonz... crash and doom fatigue are setting in.

Stay frosty.  Watch your six.  Keep prepared.

But, by no means, should we stop enjoying all the beauty that surrounds us.  Five days with family over the holidays was a good reminder to me that life marches on and there is still much beauty in it.

I'm still stackin' and packin' but it isn't 'who' or 'what' I am.  It's just a part of what I do.  And should I ever be glad I did, all the better.  Meanwhile, I still go to sleep at night counting bankers hanging from street lamps... It does bring a smile to my face.

Oldwood's picture

You just can't measure a recovery by financial metrics, you have to have a recovery of mind. You are great! You are smart! And everyone loves you! What else could be more important. Think of all the good you are doing with the wealth that has been stolen from you. When you see these massive mansions that bankers are buying their girlfriends, be proud and know you helped pay for that. We are "winning" yet too many just don't know it. We must simply believe in the messiah and be saved. Blessed is the Obama.

(a little vomit just came up in my throat)

got to go brush my teeth again

Yardfarmer's picture

it does seem that the constant reiteration of the now very tiresome theme of impending doom has been pressed to the point of saturation and thus absolute meaninglessness. just remember that just because the predicted and expected consequences of some very decidedly tyrannical government and social policies and equally disastrous economic programs have not yet yielded the foreseen results (at least in your neighborhood) the absolute invariables remain active and fully engaged. the little boy crying wolf is an essential part of the paradigm which at the precise juncture when the cries of alarm finally have no apparent effect the ultimate outcome will be hard by the door. 2014 will usher in yet another and perhaps critical implementation of the incremental progression to the cyclic phase transition which will come suddenly and with a by now highly unexpected force. as with everything of importance, one must remain patient, vigilant and above all prepared for any outcome. 

GetZeeGold's picture



I applied for my too big to fail status this week.......hope to hear back by next week.

mayhem_korner's picture



Check yer mailbox for things stamped "pre-sorted" - should be in there...

TeamDepends's picture

Holy shit!  Metals just got pole-axed!

GetZeeGold's picture



Expect more of that as we near the logical conclusion......hopefully we can get it to zero.....along with unemployment.

mayhem_korner's picture



Paper metal, that is.  All part of the narrative: "stawks are the only place to be, ever."  (Unless of course you are among the majority that have no available capital to "invest").

Abby Normal's picture

I would argue that most cultures fail when consequences of actions are muffled or avoided altogether.  Yet, it seems like every culture tries to avoid consequences until they run out of resources and fail.  It's not just the financial markets, it's everything including taking care of your work, your health and your family.  When will the US change back to the principles it started with?

mayhem_korner's picture

When will the US change back to the principles it started with?


It won't.  The principles of responsibility, individual sovereignty, and natural law are as kryptonite to the statists who have wedged their way into powerAnd they have set up a power structure that will continue in perpetuity absent a concerted and coordinated act of force removing it.

(gotta run - drone just circled the ranch)

new game's picture

yo blow dat bub...

Greenskeeper_Carl's picture

risk can be seperated from gain, because obama. FOARWARD!!! nah, Im just kidding. we're fuckin doomed

GetZeeGold's picture



So we have that going for us......which is nice.

q99x2's picture

Everyone has to stop using the dollar now if you don't want to be killed by the globalists. They have amassed a historic arsenal of weaponry to destroy their enemies. That arsenal is paid for by counterfeit dollars. The money from you and I is taken from us and given to the globalists by way of counterfeited dollars. Stop using them.

Oldwood's picture

Trying to eliminate risk is the same as trying to put out a fire with gasoline. The more they bury it the larger it becomes. Risk is essential. The best defense to risk is its visibility. We need to to be able to see risk just like we need headlights when driving at night. They want to obscure the headlights and instead of providing vision, want to sell us more insurance against the inevitable crash. This is fucked up stupid, but people love it. They love the warm embrace of security and will pay dearly for it, even if it makes the odds of their demise even greater. Pure madness, but lots of people making lots of money from it. Derivatives anyone?

mayhem_korner's picture



It is not the frequency with which you are right that counts, but rather the cumulative effect of your losses.  N.N. Taleb


Great post, although I think the 2014 prediction at the end could have been left off.


Hedgetard55's picture

Ben has destroyed the  price transmission mechanism known as interest rates. It is the equivalent of cutting the nerves in your hand so you feel nothing. Eventually your hand will go someplace it does not belong, like a flame, and you will not realize it until it is turned to ash.

Racer's picture

They eliminate risk for the psychopathic banksters, yet the people who put money in banks with not enough reward in interest, risk having it stolen from inside the bank. High risk for the sheeple, none for banksters

SheepDog-One's picture

'The FED's campaign to re-start the U.S. economy'....wow, talk about not getting it. The FED has been doing a bank heist operation, robbing us blind, while guys like this think the FED is trying to help us. No wonder we're so screwed.

Happy New Year, you filthy animals!

falak pema's picture

when acme meets acne; the pimple becomes the cause of system failure.

Dat pimple on Potus's nose...dat awful puss filled festpool of derivative easy money printing alldaway to QE infinty...

"Hey fellas ! Wazz the problem? We be land of the freebees, we all go to heaven. So relax! Whatever we do ! 'Cos we be land of the brazen, oops, of the brave!...  The chalice from the Potus Palace has the brew that is true ! Its the vessel with the pestle that has the poisonous pellet!  Promise, as head of the head of the FED!

Look at those slit eyed shamans if ya wanna find the darn pestle..."

mightybillfuji's picture

There is one increasing material difference.

The various entities that have been pulling off the magic trick for the past five years are now increasingly overextended. Look at the BOJ and Japan. Look at US debt levels vs. five years ago.

Personally I think Japan may be the "Lehman" of this round and if that's the case, that particular candle is probably getting close to being lit. How can a country with what is probably getting close to 250% of GDP in debt get away from THIS APRILS trap of having to massive expand the tax rates to try to stave off a debt downgrade, which will reduce GDP, which will instantly increase the Debt vs. GDP ratio, which will cause a debt downgrade....

Its only going to take one crack in this dam....

KickIce's picture

Risk, along with just laws that are applied accross the board are the forces that keep greed in check.

We obviously have neither.

search's picture

Shit, you think risk separated from gain is doom? Risk tied to gain you got Maheras at Citi and the top down of O'Neal to Fakahany, Cayne to Spector and Cioffi. Define your parameters more clearly. Risk isn't separated ever, you think this time is even worse? I won't argue :)

Lucius Cornelius Sulla's picture

The FED's strategy has nothing to do with the wealth effect.  Its sole raison d'etre is to save and enrich the banks.  Its policies are fostering an environment to hold real rates negative long enough to force savers to pay for the banks lost bets.  It's moral hazard on steriods.  Inflated asset prices are merely a side effect.

lordbyroniv's picture

CHARGE !!!!!!!!!!!!!!!!!!!!!!

CheapBastard's picture

Key point:


"The strategy is simple: drive the cost of borrowing money so low that people will once again buy homes with 3% down payments and huge mortgages, and plow their money into the stock market, the asset class (along with real estate) which is inflated monthly as an official Fed policy."

SweetDoug's picture





Ah yes! But nowhere, does it say, that the banksters must lend you the money, or will have more impetus to do, just because the rates are so low!


As my dear old dad said, that I now apply regarding risk and reward… "If you want to chop the wood, you hold the axe!"


Words to live by.


Words to die by.


sosoome's picture

You make an excellent case for there being no federal deposit insurance.

I Write Code's picture

Separating risk and gain was (and is) what the derivatives market is all about.  All them financial rocket scientists think they can do it, and the banksters are so proud of this expertise they pay themselves billions for doing it.  And this is exactly what failed in 2008.  It can't be done.  All you can do is FRAUDULENTLY claim that you have done it, and sell the results to suckers.  And go crying to Bernanke the next time it craters so he can dry your tears with wads of newly printed currency.

rosiescenario's picture

The investors in LTC all believed that the rocket scientists had eliminated risk.


Risk always becomes apparent after the fact; obviously, if it were apparent beforehand, it would be avoided.

sangell's picture

There was a lot of luck involved at Midway ( and we could read Japanese code) so maybe not the right analogy. I see the Fed as being more like the Germans in WW2 thinking they had won in the West so they were free to move in the East. Nothing that caused 2008 has been fixed. The rotting mortgages were swept under the rug of the Fed balance sheet, the mountain of accumulated debt still stood there just like the RAF and Royal Navy were still there just over the horizon. Out of sight out of mind can't hurt us so lets move on and use our 'tool kit' somewhere else. In the case of Germany it was its powerful army, in the case of the Fed it was its powerful bubble machine. The Germans found the problem they papered over in Britain was not 'contained' just as the Fed is going to find that the papered over problems of 2008 still exist and they will find that out just as their 'tool kit' hits the wall in the future.

TheReplacement's picture

Sorta kinda agree but with a caveat.  Britain was not going to defeat Germany.  To do that they would need more of, well, everything.  The unforseen event was the American bubble.  Hitler acted like a Cambridge cop by declaring and giving Roosievelt the opening he needed. 

Who knows what stupid little Fed/.gov miscalculation will turn out to be a whale of a problem under the surface.  Perhaps there will be none.  Perhaps this is all part of the plan and the seeming miscalculation will be intentional.  I'd bet on the last one personally.