This paper is based on the assumption that there are two separate, but complementary,
Cantalaur effects. Intertemporal disequilibrium and systemic appraisal optimism. It develops
the analysis of risk as an important element in ABCT analysis, first advanced by Tyler
Carman and by Toby Baxendale and Anthony Evans. The role of reserve assets in the trade cycle
In the first place, businessmen are led to attempt more time-consuming investments than
there are sources to complete.
In the second place, they are led to invest in projects riskier than they believe them
to be.
The theory explains how businessmen held precautionary assets or reserve assets, Ludwig Lackman's
term, or buffer stocks, against planned disappointment, and why holdings of these assets are important,
are unimportant, but not the sole factor in determining to what degree each distortion
is caused by any given reduction in interest rates below the natural rate.
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.
The structures are interrelated and are subject to similar self-correcting processes.
In the case of the production structure, the crisis is brought about by the Ricardo effect.
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.
The existence of a risk structure and holdings of precautionary assets provides an explanation for the paradox of co-movement.
This puzzle is that during the boom, both investment and consumption expand at the same time.
This is paradoxical because the newly injected money into the loan market should draw resources from consumption to investment.
Additional resources to account for the exuberance of the boom must come from somewhere.
In conventional theory, it is hard to see where they could come from, hence the paradox.
As Tyler Cowan has put it,
co-movement of consumption and investment is an embarrassingly empirical fact
for the Austrian account of the boom.
Attempts to explain the paradox by arguing that as investment increases,
silver consumption, as time preferences have not changed, are flawed.
They fail to explain why with scarce resources,
an increase in investment spending does not lead to a reduction in consumption.
The paradox is explained by the existence of the risk structure,
which includes but is not limited to those assets which businesses hold to meet planned disappointment.
With interest rates reduced below the natural rate, business are misled into unwarranted optimism
and they reduce their precautionary assets. These assets are the resourceage which become available
to feed the co-expansion of investment and consumption. In terms of Roger Garrison's
interpretation of ABCT, the release of these precautionary assets permit economic activity
above the sustainable production frontier. This weakening of the risk structure provides
a temporary release from the scarcity constraint which is the root of the co-movement paradox.
The paper develops the theory of risk structure and the dual catalogue effects and explores
some of its ramifications. First it uses the example of the Lloyds Insurance Market to
show how systemic appraisal optimism can cause sector-wide distortions on a small scale illustrating
The second catalogue effect on the large scale.
Second, it analyses the movements in precautionary assets are important in explaining how market
economies recover from crises and the importance of allowing this recovery process to take
place without interference.
Finally, it examines some consequences for public policy.
The Lloyds Insurance Market suffered from a series of crises in the 1990s and again
in the early 2000s, which can illustrate systemic appraisal optimism, the collective underestimate
of the riskiness of the business environment. This crisis has been seen by some, notably
Sir Adam Ridley, as anticipating in microcosm the world crisis which began in 2008. In what
follows the first Lloyd's crisis, which lasted from 1991 to 1996, it is used to illustrate
the origin and effects of systemic appraisal optimism and how businesses adjust to the
and the realisation their optimism was mistaken.
The Lloyds example is useful as it effectively isolates the risk structure from the production
structure allowing clearer analysis of the former.
In passing it should be noted that the crisis affected other London market companies, not
just Lloyds syndicates, but these are better documented.
Lloyds is not an insurance company but is and was an insurance market made up of syndicates.
Each syndicate is a miniature insurance company, supported by a variety of capital providers,
ranging from individuals to subsidiaries of international insurance companies.
Lowens is the centre of the international insurance and reinsurance market, where participants
buy and sell protection for risks both primary and reinsurance, which are often too large
to be retained in domestic markets.
The losses which derive from the five years 1988 to 1992 were the result of a large underpricing
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.
There are two particular factors which led to systemic over-optimism.
First, there was a massive influx of capital to the market.
Lowest capacity, its ability to underwrite insurance business, increased from 8.5 to 11 billion.
That's on the left-hand scale and is in the form of columns.
Rates in the important marine market fell by nearly 34% in the same period.
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.
Second, there had been a long period between 1965 and 1989 when there were no hurricane losses, which significantly affected the market,
until Hurricane Hugo devastated the Caribbean and the Carolinas, causing insured losses of $8 billion in current values.
There had been no other earthquake or other catastrophic losses.
These two major factors, the inflow of capital and the long absence of significant loss,
had led to a massive underestimate of the risks run particularly in writing catastrophe-exposed business.
This gave underwriters and investors a false sense of security.
There was a period of over 20 years in which the exposure of syndicates to hurricane losses
appeared to be merely notional. This license or reduction in rates and irrational willingness to
accept risks. The relative absence of hurricanes was probably the result of the Atlantic multi-decadal
oscillation, which is a long-run cyclical atmospheric phenomenon which suppresses
North Atlantic hurricane formation by increasing wind shear. There are of course other factors,
The lowest crisis illustrates two factors, increased capital and long-run absence of
catastrophe losses as causing the extravagant systemic appraisal optimism which led to disaster.
It may be thought the inflow of capital would actually make the market more resilient to
loss.
Unfortunately, the reverse was the case as we have seen the new capital led to a fall
in rates and underpricing of risks.
Similar factors can be seen in the macrocosm of the world economic crisis, which began
in 2008, in the same way that the new capital led to underpricing of risk in the Lloyds
market, so credit expansion led to lower interest rates and similar misperception of risk in
the economies of the industrialized world.
Indeed, the AMDO, the Atlantic Multidecadal Oscillation, was to the Lloyds market, as
the Greenspan put was to the international economy, during the latter stages of the great
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
The Lloyd's microcosm offers an interesting insight into the recovery process.
The near collapse of the market led to the recapitalisation of the requirements that
Capital Providers should have more capital with greater liquidity than had been required
before.
It is no surprise that we are seeing a similar rebuilding of balance sheets as part of the
recovery process after the economic crisis.
The theory has implications for understanding crises and subsequent recessions.
With precautionary asset stocks run down in the boom, businesses lack resilience and become
vulnerable to shocks.
They might have been able to absorb dislocations easily when precautionary assets were high
at the start of the boom, having underestimated the riskiness of the business climate and
made losses. As a result, businessmen rebuild their precautionary assets in line with their
perception of actual riskiness. Businesses seek to reestablish their ability to withstand
shocks in line with reality rather than the exaggerated optimists of the boom. This reshuffling
of the risk structure restores businesses to a posture in line with actual riskiness
Business of Economic Activity, one of the mistaken optimisms of the boom.
This reconstituted risk structure of the economy after the errors of the boom is as important
for sustainable recovery as the rearrangement of the production structure in line with actual
savings and time preferences.
If the risk structure is not restored, then there is a risk of continued economic instability.
Thus, if precautionary assets are below the level appropriate for the actual risk environment,
Things will be unduly cautious and their money and their recovery will be sluggish.
Thus, an economy with an appropriate stock of precautionary assets will recover more
quickly than one without.
Note that if the precautionary assets are held above the required level for actual risk,
no serious systemic ill consequences follow.
This asymmetry means only that the economy becomes more resilient than necessary and
the excess precautionary assets are wasted.
This process of expansion and contraction of precautionary assets applies to banks as
much as it does to other forms of business and for exactly the same reasons.
Having underestimated the riskiness of the business conditions during the boom and the
unexpected deterioration of their loan box, banks seek to restore their capital and their
liquidity.
Only when this has been achieved will they be able to return to their legitimate function
of mediating between savers and businesses.
Any deflation generally falling prices may have the effect of pushing real interest rates
above the natural rate, in which case business will be misled into thinking that the business
environment is more risky than is actually the case.
As a result, they will be reluctant to invest in projects in which normal conditions of
systemic appraisal neutrality they would find well within their risk frontier.
They may then build up greater amounts of precautionary assets than are actually necessary
and the recovery may take longer than will be the case otherwise.
This may offer a significant partial explanation of the length of the Great Depression of the
1930s.
Prices fell by nearly a third in the United States in the early 1930s.
Figure 3 shows how prices fell in the US from 1930 to 1933 as a result of the collapse of
and the banking system and the resulting contraction of the money supply.
Prices were falling for nearly three years, this period from 1931 to 1933.
Figure 4 shows US real bond yields, Moody's AAA corporate bonds between 1929 and 1938.
It can be seen that at the height of the depression, real yields quadrupled
From 4% to nearly 16%, this is a whacking great jump here.
These extraordinarily high real interest rates must represent in part an apparent increase in risk premiums, which will have slowed the recovery.
Because of the fall in prices, business will be misinformed that the risk environment was far worse than was actually the case.
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.
This process offers an insight into the theory of the liquidity trap, which should be represented as a downward spiral of caution.
It may just be the reaction of businesses to this misrepresentation of the risk environment.
In other words, the development of a liquidity trap can be seen as a result of policy areas,
Like a re-insurance company that has had its balance sheet devastated by an unanticipated catastrophe,
state businesses take extra precautions against a repetition of the economic crisis.
I think I will leave it there, but maybe to just elaborate on some outstanding questions.
One is, what is meant by risk? Is it even possible to discuss collective economy-wide
Risk and what measure risk can represent uncertainty. Is it possible to measure
precautionary assets? Lackman analyzed them in terms of commodity stocks, but the
list of precautionary assets needs expansion. Plainly cash and net assets,
i.e. after allowance for debt, are important constituents, but there are
others. They may include human capital and perhaps some inventories some of the
time. How is the risk structure to be connected to the production structure? How
and how important is the role of precautionary assets in determining the relative importance of exaggerated roundaboutness and riskiness in investment decisions.
And I really had better stop there. Thank you.