The Great Debate

By Mohamed El-Erian
The opinions expressed are the author’s own.

It is safe to say that there is broad agreement on what is most desirable for solving the Irish crisis — namely a mix of domestic policies and external financing finely calibrated to enable the country to grow strongly, create jobs, stabilize the banks, and overcome large and mounting indebtedness.

Unfortunately, what is most desirable is not feasible given the path Europe is embarked on; and, to make things even more complicated, what appears feasible to Europe is not necessarily desirable. As a result, Ireland finds itself stuck in an unstable muddled-middle. It can’t get ahead of the crisis; it is far from a first best solution; and it confronts choices that are painful to implement and uncertain in outcome.

What is evolving in Ireland today resembles what was done in Greece six months ago. Expect the Irish government to commit to even greater budgetary austerity, its European neighbors and the IMF to provide massive funding, and the banks to receive liquidity, capital injections and other unconventional forms of support.

While seemingly exceptional to many, this approach constitutes the path of least resistance. In fact, it is the most feasible. But we should not confuse feasibility with desirability.

At its roots, the approach addresses liquidity but not solvency. It adds to the debt overhang rather than reducing it. And it uses the socially-painful method of income and growth compression as the principal way to promote international competitiveness over time.

Investment strategies designed to benefit from tail risks are fast becoming the next bubble. Investors are paying over the odds to reap benefits from remote catastrophic risks and are ignoring more moderate but much more likely outcomes that will cost them a great deal in the interim.

Following the banking crisis and the flash crash, Wall Street is rushing to meet demand from investors wanting to make money from betting on extreme market dislocations and other “black swans” by taking long positions in rare, high-impact events at the tail ends of probability curves.

Bets on tail risks have become increasingly popular and come in a variety of guises. Buying out-of-the-money puts on the major stock averages to benefit in the event of another crash; commodity futures and options to benefit from resurgent inflation or a sudden supply disruption in supply; or physical gold and long-dated Treasury bonds to protect against deflation.

John Kemp is a Reuters market analyst. The views expressed are his own.

Morgan Stanley reduced the amount of risk-taking in its trading book last quarter, but only marginally, and boosted risk in commodities to its highest level since the financial crisis struck in summer 2008, according to the firm’s earnings release.

Morgan’s relatively high appetite for trading risk sets up an intriguing contrast with Goldman Sachs, the other leading commodity bank, which cut risk aggressively across most asset classes, including commodities, in the three months April-June. Morgan Stanley cut firm-wide value-at-risk (VaR) to an average of $139 million per day, down just 2.8 percent from the first quarter’s $143 million, and slightly up from $132 million in the same period a year earlier. In contrast, Goldman cut firm-wide VaR more than 15 percent in April-June compared with the previous quarter.

Morgan Stanley boosted the VaR allocated to commodity risk slightly from $27 million to $29 million, while Goldman slashed its own commodity exposure from $49 million to $32 million. Goldman and Morgan Stanley have traditionally dominated commodity trading. But in recent years Goldman’s commodity exposure has outpaced its rival, in line with Goldman’s greater appetite for trading risk. The contrasting performance in Q2 2010, with Goldman taking risk off while Morgan Stanley continued to boost it, suggests the gap might be starting to close.

- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

A willingness to differentiate between risk on a country or at a regional level is an important part of the repair process in financial markets.

Credit worthiness is at the core of any assessment of risk and naturally credit worthiness can sort "risk" into a hierarchy which should be instrumental to the pricing of assets and currencies.

Our recent post on the End of Capitalism triggered much interest and comment.  There were plenty of diverse views, as one would expect. But one thread that came out was that what we are now seeing is not true capitalism (nor, of course, is it old-style communism). Ok, but what is it?

Anthony Conforti suggested in a comment that we need a name for what is happening,:

The first step in defining a new economic paradigm is coming up with the proper terms…new words to define a new economic environment. As words, “capitalism”, “communism”, “socialism” may now be inadequate to describe the emerging economic reality. We need new nomenclature. Any thoughts?

Hard to imagine with financial markets still buoyant and newspapers full of tales of bonus greed, but there is still the possibility that captialism will end.  At least there is according to prestigious investment consultants Watson Wyatt in their latest study called "Extreme Risks".

The firm listed the demise of the system of private ownership as one of 15 threats to investors and the global economy that probably won't happen but which it reckons are worth worrying about anyway. The idea behind the report is that such things as climate change, the break up of the euro zone and war are always worth being included in an investment risk management process.

As for the future of capitalism:

In our view, the most likely scenario is moving along from one end of a spectrum where market is king (minimum regulation) towards the other end, where we could see more onerous regulations and government intervention in, and control of, the economy. The extreme risk, however, is the demise of the capitalist system and the end of the market as the primary means of resource allocation.

Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors -- maybe even you and me.

Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading -- bets made for a bank's own behalf -- is really just a small part of their business.

Lately, Wall Street's captains of capitalism have been aggressive in pushing the "we take big risks for our customers, not for ourselves" line of argument.

– Preston Keat is director of research at Eurasia Group, a global political risk consultancy, and author of the forthcoming book “The Fat Tail: The Power of Political Knowledge for Strategic Investors” (with Ian Bremmer). Any views expressed are his own. For the related story, click here.

There are a number of macro risks that will continue to grab headlines in 2009, including the conflicts in Afghanistan and Iraq, cross-border tensions and state instability in Pakistan, and Iran’s 
ongoing quest to develop advanced nuclear technologies.

These risks are real, and will not be resolved easily or quickly. But there are two other general groups of political risks that could be defining both for investors and policy makers: first, the prospect of a number of interrelated market risks in developed and emerging Europe, and second, the challenges faced by the United States regarding multilateral leadership (particularly in the area of financial regulatory reform).