Risikolosgesellschaft

Key Takeaways

• A riskless society is a theoretical concept where all risk can be insured away.
• Arrow-Debreu general equilibrium theory assumes a world without any risk.
• Critics argue that real markets aren't perfectly competitive and can't eliminate all risk.
• Financial markets have tried to manage risk with instruments like derivatives, sometimes increasing overall risk.
• A riskless society also refers to policies aimed at reducing societal risk through regulation.

What Is a Riskless Society?

A riskless society is a fictional economic concept where markets are so complete that every conceivable risk can be insured away. Arrow-Debreu general equilibrium theory uses this assumption to strip risk from the math and focus on market interactions. Critics point to uninsurable risks and human behavior, while the article looks at how the idea connects to modern finance and regulation.1

Concept of a Riskless Society

The modern concept of general equilibrium as developed by Kenneth Arrow, Gerard Debreu, and others in the 1950s attempts to explain the complex interactions between commodity supply, demand, and prices across multiple interconnected markets.1 In 1972, Arrow was a co-recipient of the Nobel Memorial Prize in Economic Sciences. Debreu was awarded the Nobel Prize for his work in equilibrium theory in 1983.2

In their theory, markets are assumed to be complete, or in other words, markets function with no transactions costs and perfect information and that for any economic good, a market exists where that good can be traded in order to balance the underlying forces that drive supply and demand and create a market price for that good. This includes markets for insurance (or the financial management of risk); for any type of risk, a market exists to provide insurance to fully manage that risk.

Important

The riskless society assumption greatly simplifies the mathematical derivation and expression of their theory, because it eliminates the need to explicitly model any risk, uncertainty, or probabilistic outcomes for any of the economic phenomena that the model incorporates or seeks to explain.

Critiques and Challenges of the Riskless Society Model

The theory is a mathematical model based on perfectly competitive markets, and therefore it does not necessarily align with the way that economies are structured and function in the real world. Critics of the riskless society model argue that equilibrium theory stands in opposition to much of the empirical evidence the markets provide us with. They argue that the riskless society model does not adequately take into account rare events, such as catastrophes. Furthermore, it does not address the role that fear or other emotions may play in influencing decision-making. Modern behavioral finance theory attempts to study markets under states of non-equilibrium.

In the real world, risk happens, and markets for insurance are not complete. The quest to manage financial, personal, and other types of risk has spawned major markets for insurance and derivatives, non-market-based institutions to share risk, and vast bodies of government regulation to prevent people from taking certain risks or bail them out when risks go bad.

Since Arrow and Debreu's work was first published, the prevalence of financial derivatives products has grown exponentially. However it may simply not be possible to actually insure all risk, and some have even argued that attempting to do so only magnifies long-term catastrophic risk when the risk management tools themselves fail. Complex financial instruments that were presented as mitigating risk, including derivatives, played a contributing role in the 2008 financial crisis and Great Recession.

Fast Fact

The sociologist Ulrich Beck challenged this notion and argued that we are instead living in a "Risk Society," whereby human society must confront and manage risks every day, not to avoid them.3

Broader Implications and Usage of 'Riskless Society'

The term riskless society is also used outside the specific domain of theoretical economics. Often, it is a phrase that comes up in discussions of regulation, risk, and public safety.

Lawmakers and administrators may implement increased rules and regulations aimed at protecting public health or preventing accidents, with the aim of minimizing societal risk. Examples of such policies might be statewide requirements that motorcyclists wear helmets or that limit hazardous chemicals in the workplace. Critics of such regulation argue that a riskless society is an impossibility, and that additional rules impose an unnecessary burden while constraining people's ability to make free choices.

What Is a No Arbitrage Principle?

No-arbitrage is a theoretical concept that states that if markets are efficient, then there are no opportunities for risk-free profits (i.e., arbitrage). Or, if mispricings do arise, they are immediately eliminated by market participants.

What Is a Riskless Transaction?

As the name indicates, a riskless transaction cannot result in a loss. These are, however, theoretical concepts only, since even real-world arbitrage opportunities have certain amounts of transactional risk and associated costs such as commissions, fees, and taxes.

What Is General Equilibrium Analysis?

General equilibrium looks at the macro-economy as a whole, instead of analyzing individual assets or markets (in what is known as partial-equilibrium analysis). This type of analysis employs aggregates such as aggregate supply and aggregate demand.

What Is an Arrow-Debreu Security?

Also known as an Arrow security, this is a theoretical investment that has different payouts depending on different states of the world. Commonly, economists propose that these assets will pay out $1 if and only if a particular state of nature occurs; otherwise, they pay out zero.4