Reducing Risk

Think back oh, I don't know, fifteen years. It's 1993. The world has just recovered from a recession and economic growth is finally on the up. But unemployment remains too high for comfort and people talk about a "jobless recovery" while a young(er) Bill Clinton begins to contemplate strategies for reducing public debt.

And Nirvana, of course, releases In Utero.

It was definitely a strange time. In Utero was released after the success of Nevermind catapulted Nirvana from alt-rock trendiness to mainstream success. Overnight a struggling band had become millionaires and the music world was changed forever. But... In Utero? What went on there? It wasn't as though the album wasn't a success - it was (it reached no. 1). Nevertheless there was a sense of disappointment that many new Nirvana fans felt. Gone were the Gen-X anger anthems, replaced by a depressed sense of self loathing that made the band more British than American.

In retrospect, however, In Utero is Nirvana's most critically acclaimed work. It has stood the test of time and is deservedly viewed by fans as the band's creative and musical peak. At the time, though, it was a risk.

Risk and reward are two very obvious and very common concepts that our society uses. Most of the time it is an unconscious decision. In the financial and economic world, however, risk is a quantifiable condition that governs how much should be lent out and at what terms.

And fifteen years ago, risk aversion certainly affected the economic world as it climbed out of a recession and into a jobless recovery. The early 90s downturn was not as vast or as damaging as the early 80s one, but it did serve as a reminder that even the best efforts of exuberant Reaganomics could meet natural limits.

But between then and now, something happened. First a tech bubble popped, leaving the US in recession in 2001, and then the subprime bubble popped in 2006, leading to a credit crisis in 2007 and then the proto-depression that we are going through now. At some point between 1993 and 2001, the market's ability to accurately measure risk disappeared. Yet no one seemed to learn and risk analysis went off the rails yet again as the housing bubble promised heaven on earth and delivered hell on earth instead.

You've seen people who get into destructive relationships and then, after a period of healing, enter into another destructive one? Well, that's pretty much what has happened in the last ten years with risk analysis.

I was interested to read at Mark Thoma's site today the story of Nassim Nicholas Taleb. Taleb said that Bankers “are not conservative at all; just phenomenally skilled at self-deception by burying the possibility of a large, devastating, loss under the rug”.

Taleb sounds, of course, like an angry Austrian - he doesn't use mathematical equations and Gaussian somethings - instead he uses what appear to be unprovable axioms and, from those, basically states that these people are idiots (more or less). Pre-2007 and Taleb was written off. Post-2008 and people are noticing.

One problem with modern understandings of how risk works is that often it is predicated upon historical performance. Take periods of economic growth and recession - the so called "peaks and troughs" that typify modern economic evidence. It is very easy to see these events in a closed system and as a cycle - which they are. What we may not be able to see, though, is the bigger picture. We don't factor in variables enough, resulting in a "Salient Oversight" that ends up like a sabot in an industrial machine, causing a sudden, damaging halt in the process. Taleb, along with many others, could see that the financial and economic machine was going to shut down painfully because the designers and maintenance workers of the machine - banks and financial institutions with complex risk-management equations - were blissfully unaware of their impending doom. The level of risk, therefore, was a lot higher than it appeared to be.

What do we do? If we're going to learn from the smoking, screeching machine that this economy has become, what policy goals, if any, need to be implemented?

The first area that needs to be worked on is the most obvious, and yet it is probably the least important - regulation. It was obvious from the outset that the entire financial industry became lazy during the late 1990s. Risk wasn't important while share prices soared. Instead of basic questions like profitability and p/e ratios and long term goals, the focus instead was upon candlesticks and lines of resistance and Fibonacci sequences. In other words, the focus of finance was upon the practice of finance, rather than the companies that needed finance.

Which is why the US economy then began to be mainly a "financial" economy - high share prices created paper profits which created higher share prices until a very impressive house of cards was built. Better regulation would certainly have helped the focus stay upon real-world measures of wealth and may have helped reduce the pain that many are suffering now.

But it is the second area that I want to focus upon here - the importance of interest rates in determining risk.

Whenever interest rates increase - and by this I am talking about the Federal Funds rate (or foreign equivalent) - the entire market for lending moves towards a more risk-averse environment. This is because, by increasing rates, the Federal Reserve is essentially increasing the competition for the investor dollar. Since US government bonds are (rightly) seen as a risk-free security, any increase in bond rates will make other forms of investment more riskier by comparison.

Conversely, whenever interest rates decrease, the environment becomes more risk-friendly. By lowering rates on government bonds, other forms of investment become more attractive.

So, in summary:
  • Increasing rates = less riskier investing.
  • Decreasing rates = more riskier investing.
I'm not one of these people who somehow sees debt and risk as being bad things - they're good things, but only when balanced with savings and safety. Just as over-borrowing and investment in high risk ventures can result in economic carnage, so can over-saving and investment in low risk ventures result in a low-speed, sluggish economy.

The issue here, though, is balance. The market should be allowed to invest in riskier ventures if it sees it as being profitable while also being given allowances to be conservative.

The problem, though, is when interest rates remain too high or too low. I have argued that since 2002, the Federal funds rate was too low. This resulted in negative real interest rates and the creation of the subprime bubble.

And because interest rates were too low, the market responded by investing in an area that seemed reasonable and profitable at the time, but was eventually proven to be too high a risk - the property market. Had interest rates been higher, and had real interest rates been positive from 2002 onwards, the chances are that the subprime bubble would have popped earlier or maybe not even formed at all. In fact, the higher the interest rate was, the less chance a bubble would've been formed in the first place.

All this goes back to what I have been arguing about the importance of maintaining value in a currency. As I said before, currency is unique in that it is both a unit of measurement and a commodity that is bought and sold. When money changes in market value, its usefulness as a unit of measurement is ruined. In practice, inflation forces the market to over-invest in high-risk ventures. By contrast, deflation forces the market to under-invest in ventures that are not very risky at all.

In order for the market to make more rational decisions, money must remain a stable and predictable unit of measurement while still being bought and sold as a commodity. To find the balance between risk-friendly and risk-averse, interest rates must act as a compensator to prevent the market from going too far in either direction. Absolute Price Stability (neither inflation nor deflation over the long term) should therefore be seriously considered as the means by which central banks run monetary policy.

Risk will always be a part of modern financial investment and behaviour. As I have said before, risk is not wrong - but too much of it is. Neither is conservative investment wrong - but too much of it is.

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