The end of safe havens

By Felix Salmon
November 11, 2009
Ryan Avent:

If everyone is certain that crises are going to be bigger and more frequent, and if everyone is certain that governments won't be able to afford to bail everyone out the next time around, then shouldn't everyone be busy limiting their exposure to risk? And shouldn't that then reduce the likelihood, frequency, and cost of future crises?

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I’m surprised to see this coming from Ryan Avent:

If everyone is certain that crises are going to be bigger and more frequent, and if everyone is certain that governments won’t be able to afford to bail everyone out the next time around, then shouldn’t everyone be busy limiting their exposure to risk? And shouldn’t that then reduce the likelihood, frequency, and cost of future crises?

Firstly, everyone isn’t certain that crises are going to be bigger and more frequent. To the contrary, there’s a strong urge among a large swathe of the markets to dismiss this most recent crisis as a once-in-a-century event and embrace the notion that we’re getting “back to normal”.

But more to the point, as I’ve said many times in the past, the most recent crisis was in many ways a consequence of precisely what Avent is talking about here — everybody being busy limiting their exposure to risk at the same time. The crisis wasn’t a function of too many people taking on too much risk and then coming a cropper — it was much more a function of too many people being incredibly overcautious and demanding limitless quantities of risk-free triple-A-rated paper.

The fact is that if the rest of the world is out there taking risks, then it’s quite easy for an individual investor to limit their risk exposure and be safe. But if everybody tries to be safe at the same time, that creates the biggest risks of all — and yes will increase the severity of any crisis.

Besides, there really isn’t an easy or obvious way for an investor to be highly risk-averse in this market, not when one of the biggest tail risks that people want to protect themselves against is inflation. Big investors can try taking the Taleb approach of buying large numbers of out-of-the-money options and reckoning that a bunch of them will pay off when the next crisis hits, but that’s not a strategy available to most of us. There’s only downside and no upside in lending money to the US government or your local bank at near-zero interest rates, and buying gold at $1,100 an ounce looks like a crazy speculative momentum play more than a flight to safety.

Personally, I’m quite glad that there’s no obvious safe haven these days: it forces investors to come to terms with the fact that investing, by its very nature, must and should involve taking calculated risks. When people try to flee to safety, markets fail.

3 comments

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Keep making this point, Felix. Its right on. If there is nobody who can give a good return with good guarantees, every individual must find their own investments. Invest in your own education, invest your own money in your own business, your own rental property with you as a landlord. Or do your own research and find your own public risk assets like stocks. Invest in energy-efficient appliances and windows. Even consumable commodities are something, if they are physically warehoused at low cost. Best yet if you have money in need of a home: have more kids, a crucial but almost forgotten investment in much of the developed world.

The flight to riskless was a flight away from ownership in real things. And this created (and continues to create) the mother of all agency problems as capital is destroyed by agencies that are poor stewards or can’t see granular opportunities. Governments spend precious savings on wars and handouts, financial managers help themselves to huge shares of returns which capital they blow on luxury consumption.

These problems could be helped with better stewardship by the agencies. Governments could make real investments in the future: life-improving science, medical research, infrastructure and education. Bankers could give customers more of their returns back.

Posted by Dan Hess | Report as abusive

“The crisis wasn’t a function of too many people taking on too much risk and then coming a cropper — it was much more a function of too many people being incredibly overcautious and demanding limitless quantities of risk-free triple-A-rated paper.”

By then the horse was gone.

It was NOT overcautious in the earlier phase to accept anything as triple-A-rated paper.

“there really isn’t an easy or obvious way for an investor to be highly risk-averse in this market, not when one of the biggest tail risks that people want to protect themselves against is inflation.”

Huh? TIPS are both easy and obvious. While the definition of inflation varies (among bloggers, at least) to be something other than CPI, the “tail risk” inflation you refer to is clearly CPI inflation. TIPS protect quite well against this, since they are explicitly linked to CPI. The downside of TIPS is the risk of deflation, but it is hard to call deflation a “tail risk.” Has any developed economy ever experienced hyper-DEFLATION?

Posted by maynardGkeynes | Report as abusive