Friday, June 02, 2006

Risk and the macroeconomy

The RBA's Deputy Governor Glenn Stevens has written an interesting, readable survey on the thesis that the global economy has become less risky. Will this improved stability self-destruct?

Developed economies have become less volatile than they have been in the past. The standard deviation of real GDP has halved in the US and more than halved in Australia since the 1950s. The standard deviation of inflation has dropped dramatically over the past 50 years in OECD countries. This reduced risk has even spread to emerging markets where, for example, credit ratings have improved significantly.

Since the probability of default rises during economic downturns the increased macroeconomic stability must reduce the individual risks businesses face though, in fact, there is little systematic evidence of a decline in equity market variability.

Stevens asks whether this apparently benign state of affairs can last. The interesting question he poses is whether the stability that has developed will self-destruct:

‘… might not the behaviour of borrowers, lenders, investors and price setters, in response to perceived lower risk, itself work to increase the probability of instability in future? This…is the question posed about the tendency of households ...to take on much more debt. In enjoying – rationally, based on lengthening experience – the opportunities afforded by a more stable macroeconomic environment and a more complete and liquid set of capital markets, are they in the process gradually impairing the very resilience to economic shocks which helped to produce the stability…?...

...Questions could well extend – once again – to some corporate entities….given the re-emergence of leveraged buy-outs, which leave the cash-flow positions of the corporations more precariously balanced. At least here there is, admittedly, more historical experience as a guide to likely subsequent behaviour.

….considerable sums of money have been risked over recent years in various manifestations of the search for yield, which depended on a degree of stability and predictability in global short-term interest rates that was unlikely – even with a more stable macroeconomy – to last for a long time...

There are also some challenging questions associated with the very rapid growth seen in credit derivative markets in recent years. Generally speaking, this should be promoting the more efficient pricing of credit risk and helping to shift it away from its intrinsic origin in businesses and their bankers to a broader set of holders who really want it. From the perspective of economic and financial stability, such a trend is to be welcomed. … the amount of leverage that can be embedded in such products is a potential source of trouble. There is also considerable uncertainty about whether, under conditions of stress, liquidity in these markets will be such as to allow risk-holders to manage their positions’.
Stevens closes with unconventional remarks on ‘global imbalances’. He sees the risks here as stemming from wrong conclusions about structural problems countries face not the imbalances per se. This might lead to protectionism flourishing which would be really damaging.

5 comments:

patrick said...

Harry, I would be intrigued to hear your thoughts on this, do you agree with his thesis?

hc said...

Stevens is very cautious - he tends to agree with the hypothesis of increased stability but the fact that this might self-destruct he poses as an open question.

Its seems plausible to me. Households take out more debt than they otherwise would and firms become more highly leveraged because they fear the trade cycle less. They over-expand and so on.

A smaller than usual blip in the economy - of the type that could be starting right now - then causes greater than usual damage because agents have been less careful than usual.

If you accept this then two things follow: (i) caution towards debt levels is appropriate and (ii) an occasional recession - despite its costs - has one beneficial effect of inducing an appropriate level of caution.

The idea is that sensitivity to recession increases the longer the period of a sustained expansion.

Nicholas Gruen said...

I agree whith your analysis Harry.

Just when you thought it was safe to go into the water . . .

One consequence of your argument is that we should remove the many things in our tax system which favour debt.

Patrick said...

I think the real point is the warning against protectionism. Debt is of course one of the pillars of civilisation - not such a bad thing.

Both points reflect an earlier post of Harry's.

Patrick may all the lefties die and rot in hell said...

PS - there are two Patrick's on this site. The one whose name links to a blogger profile is not me. I don't share his views except where explicitly stated.