Greg Ip’s risk hairball

By Felix Salmon
June 4, 2012
Greg Ip is getting in on the probabilities game, this time looking at the three big risks facing the global macroeconomy.

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Greg Ip is getting in on the probabilities game, this time looking at the three big risks facing the global macroeconomy.

Ip puts the chance of a Chinese hard landing at 20%; of the euro falling apart at 40%; and of the US fiscal cliff actually happening at 30%. Individually, each of these risks is bearable. But make the reasonable assumption that they’re independent variables, and it turns out that if you put them all together, the chances of none of them happening are just one in three.

But let’s go a bit further. Let’s say that if none of these things happen, that’s Good. If one of these things happen, that’s Bad. If two of these things happen, that’s Dreadful. And if all three of these things happen, that’s Apocalypse.

Then this is the result that you get. The chances of a good outcome are 33.6%, a bad outcome is 45.2%, a dreadful outcome is 18.8%, and the chances of apocalypse are a small but still scary 2.4%.

pie.png

You can also look at each possible outcome individually, like this:

Europe US China Probability
happy.jpg happy.jpg happy.jpg 33.6%
sad.jpg happy.jpg happy.jpg 22.4%
happy.jpg sad.jpg happy.jpg 14.4%
sad.jpg sad.jpg happy.jpg 9.6%
sad.jpg happy.jpg happy.jpg 8.4%
sad.jpg happy.jpg sad.jpg 5.6%
happy.jpg sad.jpg sad.jpg 3.6%
sad.jpg sad.jpg sad.jpg 2.4%

The most likely single outcome is the Good one, where everything goes well in all three regions. The next most likely outcome is the bad one where Europe falls apart but the US and China keep things together — that’s 22%. Then comes the bad outcome with a US fiscal cliff while Europe and China muddle through: that’s 14%. And in fourth place is the dreadful outcome where you get the US fiscal cliff and the euro falling apart: that has a substantial 10% probability.

This is what Ip calls the “big hairball of risk”, and it basically explains the flight to quality that we’re seeing globally, with long-term yields below 2% in every major currency in the world. How do you invest in such a world? It’s really hard, but most sensible strategies involve a pretty large degree of downside protection in the form of risk-free assets. “And that sort of disengagement,” says Ip, “can make economic pessimism self-fulfilling.”

Unless, of course, governments take advantage of their ultra-cheap funding to step in with massive economic stimulus.

Comments
7 comments so far

Felix,

the smile for China in the 5th row should be a frown.

Posted by MorgantownJoe | Report as abusive

Once you’ve made up a number it’s really easy to make it look pretty…

Posted by FifthDecade | Report as abusive

But make the reasonable assumption that they’re independent variables

That would require a different definition of the term “reasonable” than I am familiar with.

Perhaps “For the sake of our model, let’s assume…”

Posted by TomWest | Report as abusive

They aren’t even remotely independent. The Eurozone falling off could easily be a trigger of a Chinese hard landing, though the fiscal cliff is more political than economic (and thus harder to analyze the dependencies).

Also suspect the “Apocalypse” is an exaggeration. Would be global hard times, but then misery loves company.

Posted by TFF | Report as abusive

Agreed. I’m still trying to figure out how the failures of mutually interdependent trading partners can somehow lead to a series of statistically independent outcomes.

Posted by Frank0570618 | Report as abusive

So what assets, exactly, are risk-free at this point? What are the relative costs of carry of ammunition versus canned food?

Posted by dWj | Report as abusive

“So what assets, exactly, are risk-free at this point?”

Stocks of multinational consumer staples companies. Short of a true apocalypse, they will stay in business and continue to profitably supply our daily needs.

Maybe not completely risk-free, especially over shorter periods of time, but then nothing is truly risk-free these days.

Posted by TFF | Report as abusive
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