Outsights Fog Blog aims to help readers navigate the current opaque future faced by governments, businesses and individuals.Richard O'Brien, one of the world's leading futurists for the past 15 years and former chief economist at American Express Bank puts his combined experience to work, taking the long view of the current crisis to help readers navigate an increasingly uncertain future.

Risk and uncertainty in volatile times

With the immediate panic and shock of the crash behind us, questions are now on the minds of regulators, governments and market players across the globe: where next and how do we tackle risk? These comments reflect on a two-day roundtable in Vienna with 40 bankers, economists and regulators in December 2009. 

Lessons learnt from the crisis. The macro-economic story. Whilst economists and governments will still argue some issues heatedly (i.e. was the crash shaped by the US deficit or the Chinese surplus), it is clear that: (a) imbalances became unmanageable; (b) too much easy money was thrown at the world's financial system, encouraging gearing and debt rather than equity based investment; and (c) specific populist policies such as the Clinton/Bush strategy to increase home ownership in the USA ramped up the property bubble. Thus the bubble was encouraged by the macro context. 

The micro-economic story. The free market exploited the macro-freedoms to the full, with responsibilities abdicated all round: regulators assigned risk management to self-regulated market players; market players assigned risk analysis to ratings agencies; lenders even assigned credit analysis to borrowers (self-certified mortgages); traders and risk managers assigned analysis to models and theories; and the assets themselves were sold off repeatedly through securitisation to the point that few really knew what was in the packages they were trading. Now this lies in tatters, with Variance at Risk models, efficient market hypotheses and the like, and not a few reputations, blown to bits. 

Why was it allowed to happen? Where were the equity markets when they should have been marking prices down? Where were the regulators and supervisors when the Madoffs were making hay? Where were the institutional investors and the leaders of corporate governance? "Asleep at the switch" is the most common verdict. In the eyes of many this simply need not have happened, the boom did not have to turn into bust.  

Economists and others have been re-reading their textbooks and one of the most useful definitions I have seen is the distinction between uncertainty being non-quantifiable risk, and risk being quantifiable risk. In practical terms it means risk, being quantifiable, can be rationally incorporated in models alongside all the other numbers on returns and yields and managed accordingly. 

In contrast, uncertainty cannot be so easily packaged up into numbers and assumed away scientifically - it has to be discussed, debated and understood by all from many angles. This idea, first written up by Frank Knight, a contemporary of Keynes, underpins the essence of scenario work, where it is critical to understand there are alternatively plausible futures which cannot be conveniently ranked by probability and through numbers, but all have to be prepared for or anticipated in some way.

Part of this requires us to try to distinguish between the known risks (more quantifiable) and the unknown, uncertainties. Let me start with some big uncertainties.

1. The massive imbalances remain (between surplus and deficit countries e.g. China/USA, within Europe e.g. Greece vs others) but we do not know how the political economics behind these deficits will develop. We cannot agree whether the imbalances are caused by excess spending or excess savings, in part because this would start to lead to an assumption that responsibility for action would need to be taken by either spenders (the US etc) or China (the savers, reserve accumulators with too weak currencies). 2. There are still a lot of unknowns about the value of assets on banks' books, is there more to blow? 3. We do not know how far regulation or government intervention is required. Furthermore, do we restructure banking systems e.g. into narrow banking, or dividing up investment and commercial banking again, as re-rerun of Glass Steagall? 4. We are still finding it hard to assess the real network risks, the risk of contagion, in this complex market full of junk. Some clearer lessons are emerging at the same time.

2. Ownership is important. The fact that Goldman Sachs has emerged pretty well so far, and was the first to start short selling the mortgage market, has been attributed to the way it is still managed, largely, like an old fashioned partnership where partners were wholly at risk. So they had a very strong incentive to understand their risks. This is a more powerful incentive to effective risk taking than the incentive of a big bonus, if you are at the same time risking everything. Ownership means understanding and accepting responsibility for the downside as well as the upside. 2. An increase in capital will be needed, as a bulwark against further bankruptcies and prevention of risk contagion. We will never know quite how much but we do know that many institutions are undercapitalised and, now that government finances are heavily burdened with the bailout cost, they are no longer in a position to bailout the system again. The risk must be shifted back to the players. 

3. The cost of the bailouts, even if they will not necessarily be as large as the amounts of money thrown at markets in terms of liquidity support, means that we face a future of very weak government balance sheets. This means new taxes, new spending cuts and where things do not balance, possible devaluations and increases in inflation. 

Finally, to assign some sense of numbers to the future, when the discussions reached a point where opinions seemed to be becoming wholly bearish, I asked if there were any bulls in the room: four hands went up with one additional participant saying yes, for two years, before the next crash. 

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