Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it's easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they're low-risk, even if they're full to bursting with enormous amounts of tail risk. The answer, as I've said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt.
What Felix omits in his short post is the unwilling risk taker known as the taxpayer. A lot of the trick of investment banking is to figure out a way to transfer risks to taxpayers. And the investment bankers have gotten really good at it, particularly in the last thirty years. That is why there are those of us on the right (Russ Roberts and myself, to name two) and those on the left (Simon Johnson and James Kwak,, to name two) who are skeptical of the incumbent regulators when they say that they can control moral hazard. Our view is that the moral hazard problem is much more profound than the regulators acknowledge.
Another really profound issue, which Salmon raises, is why so many people prefer debt-like contracts to equity-like shares in enterprises. If he were to read This Time is Different, by Carment M. Reinhart and Kenneth S. Rogoff (and perhaps he already has), Salmon would have even more reason to raise this issue.
My theory is that people have the illusion (and again, government policy can foster this illusion and sometimes make it come true) that they will not be victims of default. Every individual thinks, "Of course, if I see trouble coming, I'll be able to get out (or be bailed out) before I take a loss." When a default occurs, somebody will be left holding the bag. However, as individuals, none of us believes that that we are going to be the bagholder.
Another theory I have is that governments take advantage of these individual beliefs in the safety of debt. People treat government debt as risk-free, even though it clearly is not, as Reinhart and Rogoff remind us.
Those of us with U.S. government debt in our portfolios right now are just asking to be bagholders. Maybe Congress will stop spending so much, and the debt will be paid off out of taxes. Not bloody likely. Maybe we will see rapid inflation, in which case the holders of non-inflation-indexed debt will suffer a partial default (getting paid back in cheaper dolars), and the holders of indexed Treasuries will escape unscathed. Maybe there will be a capital levy, and all of us with financial assets will have a proportion of them confiscated. Or maybe the government will decide that printing money or enacting a capital levy like a Banana Republic are actually less politically acceptable options than just paying bondholders 50 cents on the dollar.