November 07, 2012

For now I will not buy Sebastian Mallaby’s risk averting potion, it might even enhance the risks.

Sir, I refer to Sebastian Mallaby’s “Economics must heed political risk” November 7. There he mentions the idea that “The familiar statistics on gross domestic product [could be] coupled with an index of financial risk-taking, so that the usual focus on growth would be tempered by a measure of the danger that growth might suddenly implode” and creating “a forecast of output divided by a measure of the risks to the forecasts; [something akin to] a Sharpe ratio for economic growth. 

Questions: Would that increase or decrease the risks? How would that help? Could that not also result into some risks becoming exaggeratedly considered? 

Quite recently, too radical academic finance regulators, believed they could control risks in banking, by setting up capital requirements based on ex-ante perceived risk of bank assets. And, what happened? Absolute disaster! 

Not only did they ignore that a bank has other purposes than just avoiding risks, but also, worse, the risk of default became excessively considered. It was taken into account when banks set their interest rates, amounts of exposure and other terms, and so to use precisely the same ex-risks to also set the capital requirements was sheer lunacy… though the responsible geniuses, seem not to have realized it yet. 

And how on earth does Mallaby suggest the IMF gives outlook projections that are not based on some simple assumptions, but based on a more diffuse concept of political risk? Would that be more accurate, or more believable? I doubt it. It is hard enough for the IMF as is. 

The US GAO Report in 2003, subtitled “Challenges Remain in IMF’s Ability to Anticipate, Prevent, and Resolve Financial Crises” stated: “Internal assessment of the Fund’s EWS (Early Warning System) models shows that they are weak predictors of actual crisis. The models’ most significant limitation is that they have high false-alarm rates. In about 80 percent of the cases where a crisis was predicted over the next 24 months, no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.” From reading the report it is easy to understand that one of IMF’s problems is that what it opines, becomes a political and an economic risk too. 

Finally Mallaby seems to completely ignore the issue of retro alimentation of risk perceptions. When writing that if “eurozone authorities fail to contain sovereign and banking risk… Capital will flee from Europe’s periphery to the centre and from risky corporates to the remaining comparatively safe sovereigns”, he forgets that being the receptor of all that “”hot capital” flight, also carries enormous risks. 

Anyone should be free to manage risks the way he likes, and if someone wants to buy from an economic growth political risk ratio from Mallaby, he should feel absolutely free to do so. But, to sell us the institutionalization of a risk-neutralizing product, right now when our economies have been so neutralized by one of these, sounds to me too much like selling us magical potions on a country fair. So, no thanks!