WEBVTT NOTE Risk and Recovery 1 00:00:00.000 --> 00:00:09.560 This paper is based on the assumption that there are two separate, but complementary, 2 00:00:09.560 --> 00:00:15.840 Cantalaur effects. Intertemporal disequilibrium and systemic appraisal optimism. It develops 3 00:00:15.840 --> 00:00:21.400 the analysis of risk as an important element in ABCT analysis, first advanced by Tyler 4 00:00:21.400 --> 00:00:28.960 Carman and by Toby Baxendale and Anthony Evans. The role of reserve assets in the trade cycle 5 00:00:28.960 --> 00:00:56.160 In the first place, businessmen are led to attempt more time-consuming investments than 6 00:00:56.160 --> 00:00:57.960 there are sources to complete. 7 00:00:57.960 --> 00:01:01.760 In the second place, they are led to invest in projects riskier than they believe them 8 00:01:01.760 --> 00:01:02.760 to be. 9 00:01:02.760 --> 00:01:08.200 The theory explains how businessmen held precautionary assets or reserve assets, Ludwig Lackman's 10 00:01:08.200 --> 00:01:14.720 term, or buffer stocks, against planned disappointment, and why holdings of these assets are important, 11 00:01:14.720 --> 00:01:19.360 are unimportant, but not the sole factor in determining to what degree each distortion 12 00:01:19.360 --> 00:01:23.360 is caused by any given reduction in interest rates below the natural rate. 13 00:01:23.360 --> 00:01:34.360 If the theory is correct, then an economy has a risk structure as well as a production structure and both can be distorted by manipulation of interest rates below or above the natural rate. 14 00:01:34.360 --> 00:01:39.360 The structures are interrelated and are subject to similar self-correcting processes. 15 00:01:39.360 --> 00:01:43.360 In the case of the production structure, the crisis is brought about by the Ricardo effect. 16 00:01:43.360 --> 00:01:59.360 The collective malinvestment in high-risk projects with insufficient precautionary assets bring about a similar clustering of entrepreneurial error and a retrenchment and rebuilding of depleted precautionary assets once the optimism of the boom is revealed as exaggerated and misplaced. 17 00:01:59.360 --> 00:02:07.360 The existence of a risk structure and holdings of precautionary assets provides an explanation for the paradox of co-movement. 18 00:02:07.360 --> 00:02:13.360 This puzzle is that during the boom, both investment and consumption expand at the same time. 19 00:02:13.360 --> 00:02:21.360 This is paradoxical because the newly injected money into the loan market should draw resources from consumption to investment. 20 00:02:21.360 --> 00:02:26.360 Additional resources to account for the exuberance of the boom must come from somewhere. 21 00:02:26.360 --> 00:02:32.360 In conventional theory, it is hard to see where they could come from, hence the paradox. 22 00:02:32.360 --> 00:02:34.920 As Tyler Cowan has put it, 23 00:02:34.920 --> 00:02:39.320 co-movement of consumption and investment is an embarrassingly empirical fact 24 00:02:39.320 --> 00:02:41.320 for the Austrian account of the boom. 25 00:02:41.320 --> 00:02:45.160 Attempts to explain the paradox by arguing that as investment increases, 26 00:02:45.160 --> 00:02:50.440 silver consumption, as time preferences have not changed, are flawed. 27 00:02:50.440 --> 00:02:53.320 They fail to explain why with scarce resources, 28 00:02:53.320 --> 00:02:58.040 an increase in investment spending does not lead to a reduction in consumption. 29 00:02:58.040 --> 00:03:01.640 The paradox is explained by the existence of the risk structure, 30 00:03:01.640 --> 00:03:09.000 which includes but is not limited to those assets which businesses hold to meet planned disappointment. 31 00:03:09.000 --> 00:03:15.320 With interest rates reduced below the natural rate, business are misled into unwarranted optimism 32 00:03:15.320 --> 00:03:20.680 and they reduce their precautionary assets. These assets are the resourceage which become available 33 00:03:20.680 --> 00:03:25.480 to feed the co-expansion of investment and consumption. In terms of Roger Garrison's 34 00:03:25.480 --> 00:03:31.480 interpretation of ABCT, the release of these precautionary assets permit economic activity 35 00:03:31.480 --> 00:03:36.680 above the sustainable production frontier. This weakening of the risk structure provides 36 00:03:36.680 --> 00:03:42.720 a temporary release from the scarcity constraint which is the root of the co-movement paradox. 37 00:03:42.720 --> 00:03:46.720 The paper develops the theory of risk structure and the dual catalogue effects and explores 38 00:03:46.720 --> 00:03:52.120 some of its ramifications. First it uses the example of the Lloyds Insurance Market to 39 00:03:52.120 --> 00:03:58.880 show how systemic appraisal optimism can cause sector-wide distortions on a small scale illustrating 40 00:03:58.880 --> 00:04:01.800 The second catalogue effect on the large scale. 41 00:04:01.800 --> 00:04:06.300 Second, it analyses the movements in precautionary assets are important in explaining how market 42 00:04:06.300 --> 00:04:12.560 economies recover from crises and the importance of allowing this recovery process to take 43 00:04:12.560 --> 00:04:14.000 place without interference. 44 00:04:14.000 --> 00:04:19.120 Finally, it examines some consequences for public policy. 45 00:04:19.120 --> 00:04:24.400 The Lloyds Insurance Market suffered from a series of crises in the 1990s and again 46 00:04:24.400 --> 00:04:30.560 in the early 2000s, which can illustrate systemic appraisal optimism, the collective underestimate 47 00:04:30.560 --> 00:04:35.600 of the riskiness of the business environment. This crisis has been seen by some, notably 48 00:04:35.600 --> 00:04:42.120 Sir Adam Ridley, as anticipating in microcosm the world crisis which began in 2008. In what 49 00:04:42.120 --> 00:04:47.520 follows the first Lloyd's crisis, which lasted from 1991 to 1996, it is used to illustrate 50 00:04:47.520 --> 00:04:52.360 the origin and effects of systemic appraisal optimism and how businesses adjust to the 51 00:04:52.360 --> 00:04:55.600 and the realisation their optimism was mistaken. 52 00:04:55.600 --> 00:05:00.060 The Lloyds example is useful as it effectively isolates the risk structure from the production 53 00:05:00.060 --> 00:05:03.680 structure allowing clearer analysis of the former. 54 00:05:03.680 --> 00:05:08.120 In passing it should be noted that the crisis affected other London market companies, not 55 00:05:08.120 --> 00:05:12.640 just Lloyds syndicates, but these are better documented. 56 00:05:12.640 --> 00:05:18.460 Lloyds is not an insurance company but is and was an insurance market made up of syndicates. 57 00:05:18.460 --> 00:05:23.220 Each syndicate is a miniature insurance company, supported by a variety of capital providers, 58 00:05:23.220 --> 00:05:27.300 ranging from individuals to subsidiaries of international insurance companies. 59 00:05:27.300 --> 00:05:31.100 Lowens is the centre of the international insurance and reinsurance market, where participants 60 00:05:31.100 --> 00:05:36.540 buy and sell protection for risks both primary and reinsurance, which are often too large 61 00:05:36.540 --> 00:05:40.140 to be retained in domestic markets. 62 00:05:40.140 --> 00:05:47.580 The losses which derive from the five years 1988 to 1992 were the result of a large underpricing 63 00:05:47.580 --> 00:06:09.580 Miss Pricing was not limited to any particular type of business and was in large measure market-wide. Significantly, Lloyds was, and remains, a subscription market, with risks placed amongst subscribers, taking small lines on the slip so that risks are spread widely amongst syndicates. 64 00:06:09.580 --> 00:06:13.580 There are two particular factors which led to systemic over-optimism. 65 00:06:13.580 --> 00:06:16.580 First, there was a massive influx of capital to the market. 66 00:06:16.580 --> 00:06:23.580 Lowest capacity, its ability to underwrite insurance business, increased from 8.5 to 11 billion. 67 00:06:23.580 --> 00:06:31.580 That's on the left-hand scale and is in the form of columns. 68 00:06:31.580 --> 00:06:38.580 Rates in the important marine market fell by nearly 34% in the same period. 69 00:06:38.580 --> 00:06:45.580 The inflow of capital was not matched by an increase in the risk written with the result that the unit price of each risk fell. 70 00:06:45.580 --> 00:06:55.580 Second, there had been a long period between 1965 and 1989 when there were no hurricane losses, which significantly affected the market, 71 00:06:55.580 --> 00:07:05.580 until Hurricane Hugo devastated the Caribbean and the Carolinas, causing insured losses of $8 billion in current values. 72 00:07:05.580 --> 00:07:11.580 There had been no other earthquake or other catastrophic losses. 73 00:07:11.580 --> 00:07:17.580 These two major factors, the inflow of capital and the long absence of significant loss, 74 00:07:17.580 --> 00:07:24.580 had led to a massive underestimate of the risks run particularly in writing catastrophe-exposed business. 75 00:07:29.580 --> 00:07:33.580 This gave underwriters and investors a false sense of security. 76 00:07:33.580 --> 00:07:37.980 There was a period of over 20 years in which the exposure of syndicates to hurricane losses 77 00:07:37.980 --> 00:07:44.300 appeared to be merely notional. This license or reduction in rates and irrational willingness to 78 00:07:44.300 --> 00:07:51.420 accept risks. The relative absence of hurricanes was probably the result of the Atlantic multi-decadal 79 00:07:51.420 --> 00:07:55.660 oscillation, which is a long-run cyclical atmospheric phenomenon which suppresses 80 00:07:55.660 --> 00:08:01.260 North Atlantic hurricane formation by increasing wind shear. There are of course other factors, 81 00:08:01.260 --> 00:08:11.980 The lowest crisis illustrates two factors, increased capital and long-run absence of 82 00:08:11.980 --> 00:08:18.260 catastrophe losses as causing the extravagant systemic appraisal optimism which led to disaster. 83 00:08:18.260 --> 00:08:22.260 It may be thought the inflow of capital would actually make the market more resilient to 84 00:08:22.260 --> 00:08:23.260 loss. 85 00:08:23.260 --> 00:08:28.300 Unfortunately, the reverse was the case as we have seen the new capital led to a fall 86 00:08:28.300 --> 00:08:31.140 in rates and underpricing of risks. 87 00:08:31.140 --> 00:08:37.260 Similar factors can be seen in the macrocosm of the world economic crisis, which began 88 00:08:37.260 --> 00:08:41.860 in 2008, in the same way that the new capital led to underpricing of risk in the Lloyds 89 00:08:41.860 --> 00:08:46.860 market, so credit expansion led to lower interest rates and similar misperception of risk in 90 00:08:46.860 --> 00:08:48.820 the economies of the industrialized world. 91 00:08:48.820 --> 00:08:55.860 Indeed, the AMDO, the Atlantic Multidecadal Oscillation, was to the Lloyds market, as 92 00:08:55.860 --> 00:09:00.940 the Greenspan put was to the international economy, during the latter stages of the great 93 00:09:00.940 --> 00:09:30.940 Moderation. The fall in perceived risk can be illustrated in Figure 2. This shows the CBOE VIX index, which is a forward-looking indicator of risk, and you can see here how the index fell decidedly as the boom developed. Here we had the Bear Stearns collapse, and here was the Lehman catastrophe, and the consequent jump in 94 00:09:30.940 --> 00:09:55.660 The Lloyd's microcosm offers an interesting insight into the recovery process. 95 00:09:55.660 --> 00:09:59.060 The near collapse of the market led to the recapitalisation of the requirements that 96 00:09:59.060 --> 00:10:03.540 Capital Providers should have more capital with greater liquidity than had been required 97 00:10:03.540 --> 00:10:04.540 before. 98 00:10:04.540 --> 00:10:08.580 It is no surprise that we are seeing a similar rebuilding of balance sheets as part of the 99 00:10:08.580 --> 00:10:11.700 recovery process after the economic crisis. 100 00:10:11.700 --> 00:10:15.740 The theory has implications for understanding crises and subsequent recessions. 101 00:10:15.740 --> 00:10:21.220 With precautionary asset stocks run down in the boom, businesses lack resilience and become 102 00:10:21.220 --> 00:10:23.020 vulnerable to shocks. 103 00:10:23.020 --> 00:10:27.020 They might have been able to absorb dislocations easily when precautionary assets were high 104 00:10:27.020 --> 00:10:32.060 at the start of the boom, having underestimated the riskiness of the business climate and 105 00:10:32.060 --> 00:10:37.260 made losses. As a result, businessmen rebuild their precautionary assets in line with their 106 00:10:37.260 --> 00:10:42.880 perception of actual riskiness. Businesses seek to reestablish their ability to withstand 107 00:10:42.880 --> 00:10:48.820 shocks in line with reality rather than the exaggerated optimists of the boom. This reshuffling 108 00:10:48.820 --> 00:10:54.340 of the risk structure restores businesses to a posture in line with actual riskiness 109 00:10:54.340 --> 00:10:58.260 Business of Economic Activity, one of the mistaken optimisms of the boom. 110 00:10:58.260 --> 00:11:05.060 This reconstituted risk structure of the economy after the errors of the boom is as important 111 00:11:05.060 --> 00:11:10.200 for sustainable recovery as the rearrangement of the production structure in line with actual 112 00:11:10.200 --> 00:11:12.200 savings and time preferences. 113 00:11:12.200 --> 00:11:17.180 If the risk structure is not restored, then there is a risk of continued economic instability. 114 00:11:17.180 --> 00:11:23.300 Thus, if precautionary assets are below the level appropriate for the actual risk environment, 115 00:11:23.300 --> 00:11:27.860 Things will be unduly cautious and their money and their recovery will be sluggish. 116 00:11:27.860 --> 00:11:32.260 Thus, an economy with an appropriate stock of precautionary assets will recover more 117 00:11:32.260 --> 00:11:34.020 quickly than one without. 118 00:11:34.020 --> 00:11:39.180 Note that if the precautionary assets are held above the required level for actual risk, 119 00:11:39.180 --> 00:11:42.100 no serious systemic ill consequences follow. 120 00:11:42.100 --> 00:11:48.380 This asymmetry means only that the economy becomes more resilient than necessary and 121 00:11:48.380 --> 00:11:51.480 the excess precautionary assets are wasted. 122 00:11:51.480 --> 00:11:55.420 This process of expansion and contraction of precautionary assets applies to banks as 123 00:11:55.420 --> 00:11:59.560 much as it does to other forms of business and for exactly the same reasons. 124 00:11:59.560 --> 00:12:04.600 Having underestimated the riskiness of the business conditions during the boom and the 125 00:12:04.600 --> 00:12:08.880 unexpected deterioration of their loan box, banks seek to restore their capital and their 126 00:12:08.880 --> 00:12:09.880 liquidity. 127 00:12:09.880 --> 00:12:14.120 Only when this has been achieved will they be able to return to their legitimate function 128 00:12:14.120 --> 00:12:18.060 of mediating between savers and businesses. 129 00:12:18.060 --> 00:12:26.520 Any deflation generally falling prices may have the effect of pushing real interest rates 130 00:12:26.520 --> 00:12:31.720 above the natural rate, in which case business will be misled into thinking that the business 131 00:12:31.720 --> 00:12:35.080 environment is more risky than is actually the case. 132 00:12:35.080 --> 00:12:40.600 As a result, they will be reluctant to invest in projects in which normal conditions of 133 00:12:40.600 --> 00:12:45.360 systemic appraisal neutrality they would find well within their risk frontier. 134 00:12:45.360 --> 00:12:50.240 They may then build up greater amounts of precautionary assets than are actually necessary 135 00:12:50.240 --> 00:12:53.680 and the recovery may take longer than will be the case otherwise. 136 00:12:53.680 --> 00:12:58.960 This may offer a significant partial explanation of the length of the Great Depression of the 137 00:12:58.960 --> 00:12:59.960 1930s. 138 00:12:59.960 --> 00:13:03.720 Prices fell by nearly a third in the United States in the early 1930s. 139 00:13:03.720 --> 00:13:11.360 Figure 3 shows how prices fell in the US from 1930 to 1933 as a result of the collapse of 140 00:13:11.360 --> 00:13:15.360 and the banking system and the resulting contraction of the money supply. 141 00:13:15.360 --> 00:13:21.360 Prices were falling for nearly three years, this period from 1931 to 1933. 142 00:13:21.360 --> 00:13:35.360 Figure 4 shows US real bond yields, Moody's AAA corporate bonds between 1929 and 1938. 143 00:13:35.360 --> 00:13:39.360 It can be seen that at the height of the depression, real yields quadrupled 144 00:13:39.360 --> 00:13:45.360 From 4% to nearly 16%, this is a whacking great jump here. 145 00:13:45.360 --> 00:13:58.360 These extraordinarily high real interest rates must represent in part an apparent increase in risk premiums, which will have slowed the recovery. 146 00:13:58.360 --> 00:14:06.360 Because of the fall in prices, business will be misinformed that the risk environment was far worse than was actually the case. 147 00:14:06.360 --> 00:14:18.360 Of course, to some degree, businesses may have realised that the high real interest rates represented falling prices rather than increasing risk, but this is unlikely to have been the whole story. 148 00:14:18.360 --> 00:14:25.360 This process offers an insight into the theory of the liquidity trap, which should be represented as a downward spiral of caution. 149 00:14:25.360 --> 00:14:30.360 It may just be the reaction of businesses to this misrepresentation of the risk environment. 150 00:14:30.360 --> 00:14:35.360 In other words, the development of a liquidity trap can be seen as a result of policy areas, 151 00:14:35.360 --> 00:14:40.240 Like a re-insurance company that has had its balance sheet devastated by an unanticipated catastrophe, 152 00:14:40.240 --> 00:14:45.280 state businesses take extra precautions against a repetition of the economic crisis. 153 00:14:46.880 --> 00:14:56.160 I think I will leave it there, but maybe to just elaborate on some outstanding questions. 154 00:14:56.160 --> 00:15:02.720 One is, what is meant by risk? Is it even possible to discuss collective economy-wide 155 00:15:02.720 --> 00:15:07.640 Risk and what measure risk can represent uncertainty. Is it possible to measure 156 00:15:07.640 --> 00:15:12.480 precautionary assets? Lackman analyzed them in terms of commodity stocks, but the 157 00:15:12.480 --> 00:15:17.320 list of precautionary assets needs expansion. Plainly cash and net assets, 158 00:15:17.320 --> 00:15:20.440 i.e. after allowance for debt, are important constituents, but there are 159 00:15:20.440 --> 00:15:25.280 others. They may include human capital and perhaps some inventories some of the 160 00:15:25.280 --> 00:15:29.720 time. How is the risk structure to be connected to the production structure? How 161 00:15:29.720 --> 00:15:39.720 and how important is the role of precautionary assets in determining the relative importance of exaggerated roundaboutness and riskiness in investment decisions. 162 00:15:39.720 --> 00:15:42.720 And I really had better stop there. Thank you.