One clear lesson of the recent economic turmoil was that the virtues of risk aversion were rewarded, writes David Smith in The Age of Instability: The global financial crisis and what comes next (www.vivagroupindia.com). Companies that had minimised their exposure to risk and debt during the good years were better able to survive the subsequent recession, he explains.
Stability paradox
Taking a look forward, a section in the book is titled ‘Risk aversion versus creative destruction,' as one of the ‘ten ways the world will change.' The author recommends risk aversion and avoiding excessive debt and leverage as a clear post-recession strategy, and foresees that companies will run on lower levels of debt and higher levels of liquid assets and reserves; and that in many countries individuals will also be much more debt averse than in the past. Insightful in the book is the discussion of ‘the paradox of stability' where the author frets that you may end up having too much of a good thing if, in the apparent absence of any downside danger, people take too much risk. “Stability, or, as the long period of non-inflationary growth came to be called, the ‘Great Moderation,' contains the seeds of the next disaster… Policymakers, the financial markets, firms and individuals become complacent.”
The most obvious symptom of such complacency is the acquisition of too much debt, he cautions. More dangerously — as a quote of Thomas Cooley, dean of the New York University-Stern School of Business, points out — the decline in volatility can lead financial institutions to underestimate the amount of risk they face and overestimate the amount of leverage they can handle, thus essentially reintroducing a large measure of volatility into the market.
‘Macroprudential' regulation
Among the many forecasts in the book is the expectation that the financial regulators will have a bigger macroeconomic impact than in the past. “One of the buzz phrases of the new era will be ‘macroprudential' regulation, ensuring that the actions of individual institutions do not endanger the system as a whole. Another will be counter-cyclical capital requirements, requiring banks to hoard more capital in the good times, so that they have a capital cushion against losses in the bad times.”
To those who wonder if it would be possible for the advanced economies to grow if credit were restricted, the author makes an instructive reference to ‘World Economic Outlook' of April 2009 from the International Monetary Fund, which saw recoveries to be ‘creditless'! Credit growth typically turned positive only seven quarters after the resumption of output growth, the report noted.
Sobering read.
“One of the features of the immediate aftermath of the worst of the financial crisis was that many businesses had much better credit ratings than the banks. The question for them was why they needed to use the banks as intermediaries at all, rather than borrow directly from investors. So the nature of credit may well change dramatically,” the author reasons.
Faster tilt
The book concludes with the prediction that the tilt towards the East will be faster than expected earlier. Though financial markets around the globe remained closely linked during the crisis, and some of the worst stock market falls were in emerging economies, including China, there was a distinct decoupling in economic performance, reminds Smith.
Describing the post-crisis world, in the words of Gerard Lyons, chief economist at Standard Chartered, as a new world order based on ‘an Arc of Growth, from China and India and then on to Africa, as the centre of global manufacturing shifts to regions with large and growing labour forces,' the author advises Western governments, firms and individuals to make sure their economies are tapped in to Asia.
“After the crisis, there is understandable relief that Western economies are still standing. Standing still, however, will not be enough,” urges Smith.