Is risk aversion a good option?

• Risk has always had a bit of an image problem. It is associated in the popular mind with gamblers, skydivers and, more recently, the overpaid bankers who crippled the global economy. Yet long-term economic growth would be impossible without people willing to wager all they have by starting a business, expanding an existing one or trying to invent a better mousetrap. Such risk-taking has been disturbingly scarce in America of late: the number of self-employed workers, job-creation at start-ups and the sums invested in businesses have been low.
• Though changing appetites for risk are central to booms and busts, economists have found it hard to explain their determinants. Instead, they tend to cite John Maynard Keynes’s catchy but uncrunchy talk of “animal spirits”. Recent advances in behavioural economics, however, are changing that.
• Economists have long known that people are risk-averse: Daniel Bernoulli, a Swiss mathematician, observed as much in the 18th century. Consider this simple test: given the choice, would you prefer a gift of $50, or to play a game with a 50% chance of winning $120? It might seem logical to pick the second, since the average pay-off—$60—is bigger. In practice, most people choose the first, preferring a small but certain payment to a larger but uncertain one.
• Yet the willingness to run risks varies enormously among individuals and over time. At least some of this variation is inherited. One study of twins in Sweden found that identical ones had a closer propensity to invest in shares than fraternal ones, implying that genetics explains a third of the difference in risk-taking.
• Upbringing, environment and experience also play a part. Research consistently finds, for example, that the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons. Alison Booth of Australian National University and Patrick Nolen of the University of Essex found that teenage girls at single-sex schools were less risk-averse than those at co-ed schools, which they think may be due to the absence of “culturally driven norms and beliefs about the appropriate mode of female behaviour”.
• People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.
• But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.
• This seems consistent with a growing body of research that links a low tolerance of risk to past emotional trauma. Studies have found, for example, that natural disasters such as the tsunami that hit South-East Asia in 2004 and military conflicts such as the Korean war can render their victims more cautious for years.
• The authors’ conclusions were reinforced by a separate test administered to a few hundred university students. About half were asked to watch a five-minute excerpt of a gruesome torture scene from a horror film. Then, the entire group answered the same questions about risk as the Italian bank’s clients. Watching the horror movie increased the students’ aversion to risk by roughly as much as the financial crisis had chastened the bank’s clients, although not among those who claimed to like horror movies.
• These studies suggest that the sweep and severity of the recent slumps in America and Europe will scar a wide range of people, not just those who lost money in the markets. The financial crisis is likely to inhibit them from taking the sort of risks that help propel the economy for decades to to come. Regulators and policymakers may soon be worrying about the lack of risk-takers, not fretting about their excesses.

Fiscal sustainability

• Fiscal sustainability has become a hot topic as a result of the European sovereign debt crisis, but it matters in normal times, too. This column argues that financial sector reforms are essential to ensure fiscal sustainability in the future. Although emerging market reforms undertaken in the aftermath of the financial crises of the 1990s were beneficial, complacency is not warranted. In the US, political gridlock must be overcome to reform entitlements and the tax system. In the Eurozone, creating a sovereign debt restructuring mechanism should be a priority.
• Does fiscal sustainability matter only when there is a fiscal house on fire, as was the case with the Greek sovereign insolvency in 2011–12?
•  Overcoming challenges that hinder inclusive and sustainable growth can only become possible through actionable policies and programmes if there is sufficient public funding in place, with support from the private sector. Public infrastructure, both physical and legal, for example, provides a foundation for progress in society. Further commitments of public resources are needed to ensure that this new world will be secure and stable.
• Financial support for public spending (on healthcare, pensions, infrastructure, etc.) must be funded through taxes that are clear, fair, and transparent – which is essential to their political acceptability – and that do not cause avoidable damage to the incentives to save, invest, work, and create wealth. Fairness and efficiency have intertemporal and intergenerational dimensions too, so public debt, which redistributes the burden of funding public spending over time – across generations and between different stakeholders within a generation – plays a critical role in meeting many of today’s financial challenges.
• Fiscal crises are just the tip of the public finance/sovereign funding iceberg. Even in normal times, the political and economic choices involved in determining the size and composition of public spending and the structure of the tax system are complex and often deeply divisive.
• The most remarkable feature of the fiscal sustainability crises that followed the North Atlantic financial crisis late in 2007 was that they were all advanced-economy crises, including the heartland of modern capitalism – the US, the UK, and the Eurozone. To varying degrees, advanced economies have socialised financial-sector losses caused by the crisis.
• Together with revenue losses (and automatic fiscal stabiliser-driven increases in social spending) caused by the North Atlantic financial crisis and the balance-sheet recession that followed it, this has tipped already precarious fiscal positions in many advanced economies into outright dangerous territory. For fiscal sustainability, fairness, and moral hazard reasons – that is, future crisis prevention – it is essential that financial-sector reforms be implemented to avoid a recurrence of the socialisation of financial-sector losses.
• Emerging markets and developing countries – historically the usual suspects when it comes to fiscal sustainability crises, sovereign solvency crises, and even public debt restructurings or defaults – were not on the fiscal delinquents list following the most recent financial crisis.
• The reason emerging market nations did not find themselves in the fiscal doghouse after 2007 was that the benefits of the reforms and improved macroeconomic management following the Tequila crisis of 1994, the Asian crisis of 1997, and the Russian crisis of 1998 had not been dissipated by 2008. After the painful and humiliating experiences of the Asian and Russian crises, most emerging markets cleaned up their balance sheets in the banking sector and non-financial corporate sector. Government deficits were brought down and the external current account deficits were reduced or turned into surpluses. Structural reforms to enhance the efficiency of their economies were undertaken – especially in the tradable goods sectors. Almost 15 years of export-led growth followed.
• When the North Atlantic financial crisis hit in 2007, most emerging markets were, for the first time in their histories, able to counter a recession imported from the US and Europe through effective countercyclical policy. Monetary and fiscal stimuli were applied, and most emerging markets recovered swiftly from the crisis. As advanced economies cut official policy rates to historically unprecedented levels during the period 2008–10 and engaged in rapid and large-scale balance-sheet expansions by their central banks, a ‘wall of money’ driven by a relentless hunger for yield came towards those emerging markets that were open to global capital flows; by now most of them except for China and, to a lesser extent, India.
• Attempting to counter the appreciation of their currencies that was warranted by these inflows, emerging markets accumulated foreign-exchange reserves on a huge scale. Attempts to introduce capital controls in a hurry, both administrative and fiscal, to limit inflows were unsuccessful in Brazil and elsewhere. The combination of high emerging market yields and appreciating emerging market currencies was irresistible. Macroprudential tools to stem capital inflows were embryonic, and the accumulation of forex reserves could not be effectively sterilised in most emerging markets, so domestic credit expansion imported from advanced economies resulted.
• Many emerging markets objected vociferously to these ‘currency wars’. When ‘currency peace’ broke out in May 2013, however, they did not like it any better. This was in part because after the successful counter cyclical policies of 2008 and 2009, emerging markets, instead of ceasing to stoke the fires of domestic demand, continued to fan them. India, Brazil, Turkey, Indonesia, South Africa, and many other emerging market nations permitted purely domestically generated credit booms to reinforce the imported credit booms.
• In China, the counterpart to the explosion of the banking sector’s balance-sheet size was mainly local government special purpose vehicles and corporate credit expansion. India’s credit boom also mainly involved corporates. Unlike China, however, quite a few corporates in India borrowed abroad in hard currencies, mainly US dollars. The same was true in Brazil, Indonesia, and Turkey. Corporate and banking-sector balance sheets expanded rapidly. In Brazil, for example, credit to the household sector was the main driver of balance-sheet expansion. Private-sector balance sheets became vulnerable, while external current account surpluses declined or turned into deficits. Stocks of gross external foreign currency debt, mainly issued by the private sector, also rose rapidly. The vulnerabilities were there. All that was needed for a financial ‘kerfuffle’ was a trigger. US Federal Reserve Chairman Ben Bernanke provided it through the tapering announcement of 22 May 2013.
• But even now, the balance sheet positions (or stock positions) and the budget deficit positions of most emerging market sovereigns are less vulnerable than those of the US, the EU, and Japan. There is a risk, of course, that impaired private assets from banks, corporates, or households that are either too big to fail, or too politically sensitive or politically well-connected to fail, will migrate to the public sector balance sheet, turning a private sector balance sheet crisis into a fiscal insolvency crisis.
• As noted earlier, the socialisation of financial sector balance sheet losses has indeed been the norm in the banking crises that were at the core of the North Atlantic financial crisis. The impaired assets of banks and other systemically important or politically well-connected entities were de facto implicit contingent sovereign liabilities. These implicit liabilities have since 2008 become explicit liabilities, most spectacularly in Ireland and to a lesser degree in Spain, Greece, the Netherlands, and Belgium. Slovenia’s government appears to be about to socialise at least part of the losses of its state-owned banks. Such intersectoral asset and liability migrations are not always in the same direction – i.e. they do not always involve the socialisation of private losses. In some emerging markets, notably in Argentina, there have been raids by the state on good private sector assets – the socialisation of private profits – in an attempt to restore public finances to sustainability.
• There is no doubt that emerging markets are more fiscally vulnerable today than they have been since the legacy of the 1997–98 crises. Complacency about the state of public finances in India, Brazil, Indonesia, South Africa, and even China – where there are likely to be large contingent sovereign liabilities hidden in the balance sheets of the banking and shadow banking sectors – is therefore not warranted.