Wednesday 28 September 2016

Risk managing the State, while hoping for casual miracles

David Korowicz

Published 16/08/2015 | 02:30

'Between our bank card and bread at a supermarket checkout lies a vast dance of agricultural, electric grid, telecommunications, transport, manufacturing and financial networks and infrastructures'
'Between our bank card and bread at a supermarket checkout lies a vast dance of agricultural, electric grid, telecommunications, transport, manufacturing and financial networks and infrastructures'

We take for granted what for most of human history would be regarded as a miracle.

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Our daily bread was once won by hard graft and a large share of our income or time. It was also insecure. Prior to the 19th Century, with a population less than one tenth of what it is today, local and regional famines were common throughout Europe.

Now, habituated to abundance, we're often blind to its dependency. But between our bank card and bread at a supermarket checkout lies a vast dance of agricultural, electric grid, telecommunications, transport, manufacturing and financial networks and infrastructures.

They are each interdependent. The failure of one part could cause cascading failure in other parts.

They also depend on a continual flow of inputs, maintenance, resources, people and skills that in turn depend on further factories, infrastructures, financial integration and economies of scale right across the globe.

Our broad welfare is more than ever globalised, high-speed, inter-dependent and complex - a living human metabolism and ecology without a central control or management.

This has added immensely to human welfare, but it has also increased our vulnerability to large-scale risk.

Part of its living quality is its resilience - or the ability to stabilise and self-repair. Disruption or system failure in one part of the global economy can be limited and repaired through the resilience and health of the surrounding economy.

One could think of an Argentinian sovereign crisis or of Superstorm Sandy and the enabling pattern of shock, stabilise and repair. Or Ireland's economy and society could relieve social pressure through emigration while exports and inward investment helped stave off deflationary forces.

But increasingly, the stresses we face are global, persistent and growing in number. That means that the assumption that healthier parts of the global economy can support damaged parts of the economy may be undermined as growing areas, particularly core parts of the global economy, are themselves weakened.

The most proximate stress is the decades-long build-up in global debt-to-GDP, which is greater now than when the credit bubble burst in 2008. Which means it didn't burst.

Action by central banks and governments has managed to hold off the deflationary forces that are inherent in any collapsing credit bubble.

In tandem, countries such as Ireland were forced to expand government debt to stop a potential systemic banking crisis that - whatever the rights and wrongs of the distribution of losses - could have left the European economy in a truly dire state.

While Europe was kicking the can, credit bubbles went global. From over-investment in commodity production to the suburbs of Sydney, credit over-expansion is everywhere.

China, now the world's second-biggest economy, may have supported a distressed Europe via rising imports, but it did so on the back of a stunning credit binge. Household and corporate debt-to-GDP is now 210pc, up from 125pc in 2008.

Ireland had ghost estates, China has ghost cities. But credit bubbles eventually crash, and when they do the losses will return to haunt the highly leveraged and fragile web of promises and obligations that comprise the global financial system.

While the risk of a deflationary crisis is growing, our adaptive capacity and resilience are falling. One reason is that it's more likely to be global.

The Bank of International Settlements warned in June that ultra-low interest rates have added to further dangerous risk-taking across the financial system while weakening central banks' ability to deal with the next iteration of the financial crisis.

In addition, many countries will no longer have the freedom of manoeuvre enabled by low government debt such as Ireland had in 2008.

A deflationary spiral is a cycle of contracting credit and money supply that forces GDP to contract. This leads to rising unemployment, falling wages and government income and investment, bad debts, bank failures and an increase in the real cost of debt.

Less discussed is that the complexity of modern societies and the distributed scale of the deflation would mean critical parts and inputs required for production could become unavailable for even viable business or even essential critical infrastructure.

In September 2000, many truckers in the UK, angry at rising diesel duty, blockaded refineries and fuel distribution outlets. The initial impact was on transport. People couldn't get to work and businesses could not be re-supplied.

This then began to have a systemic impact, as lack of output from one business or administrative function meant the loss of a critical input to another. There was growing contagion along just-in-time supply chains.

The protest finished after five days, at which point supermarkets had begun to empty of stock amid panic buying; large parts of the country's manufacturing sector were about to shut down; and critical societal functions were in danger of being undermined.

The lesson of the fuel blockades and subsequent analysis indicate that almost the entire operation of a complex society may be shut down if a shock of sufficient scale hits the crucial point of a complex interdependent economy.

The shock might come from anywhere - it could be financial, or maybe a major pandemic, or perhaps a major cyber-attack on critical infrastructure - but irrespective of the cause, the outcome is the same: an arrest in the flow of goods and services.

Further, the speed of our society - be that the replenishment of supply chains, or settlement in financial markets - means that the spread of a shock can be rapid.

"One week seems to be the maximum tolerance of a just-in-time economy," reported the think-tank, Chatham House.

Once that happens, a country would be entering a food security crisis, a health crisis, an administrative crisis, an economic crisis, a potential critical infrastructure crisis and a solvency and financial crisis. The longer it went on - potentially only a matter of weeks - the more difficult it would be to recover.

Clearly, the implication is that a globalised financial collapse, which we potentially came close to during the crisis, could cause contagion through global supply chains.

The rapid destabilisation of production would further destabilise the financial and monetary system in a re-enforcing cycle.

Our complex dependencies, be they socio-economic or ecological, have made us increasingly vulnerable. Persistent and growing risks, including financial, resource constraints and climate change, will increasingly test those vulnerabilities. The potential impacts could confound our expectations and fundamental welfare.

Ireland is not in control of most risk factors, but it can prepare should things go wrong.

We can never say what will happen, where it will happen or when. Risk-management is about acknowledging different potential scenarios that ideally should adapt as underlying conditions change.

A significant barrier to good risk-management is the tendency to assume that past conditions are the template for future conditions and that deviations from trend will always revert to that trend. This is often the case, but not always a good rubric.

Experience tells us that new risks that challenge our habituated expectations, world views and the comfort of the status quo are often the most difficult for a society to acknowledge and grapple with.

But if we are learning from recent experience, are optimistic rather than fearful, then we should be making a major step change in managing risk to the State, our communities and fellow citizens.

David Korowicz is a physicist and human systems ecologist working on large-scale systemic risk

Sunday Indo Business

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