In September 2010, I wrote about extreme risks—those potential events that are unlikely to occur, but if they did, would have a significant impact on economic growth and asset returns.
Towers Watson had identified 15 such risks in 2009, which were broadly grouped into three categories:
1. Financial extreme risks revolving around solvency and the ability of an institution to pay its debts with available cash. In an interconnected financial system, high degrees of leverage mean that insolvency for one institution can quickly become a systemic problem. The primary triggers for financial risks are falling asset prices and incomes or liquidity crises. Or, financial risks can be generated by a recession in the real economy and transmitted to the financial sector through defaults on loans. We saw this in the U.S. in 2008/2009 and are experiencing it now in Europe.
2. Economic risks ranging from a deflationary depression to hyperinflation and a return to the gold standard. These risks result from imbalances that create instability. Such imbalances can include household debt to income, government debt to GDP, government expenditures relative to income and the size of the financial sector relative to the economy in certain countries.
3. Environmental and political risks. This is the risk that our political structures are not equipped to deal with political crises, major war, climate change and/or pandemics.
With the eurozone and Greek crisis in full swing, revisiting the potential for extreme risks seems a worthwhile exercise. Two risks previously identified, the end of capitalism and excessive leverage, have been replaced with resource scarcity and infrastructure failure. While the end to capitalism would be incredibly disruptive, if it were to happen, there is little we could do about it, and there is little ability to plan around what might replace it. After careful consideration, Towers Watson believes that excessive leverage remains a risk but is already captured in our primary financial risk scenario, which has its root cause in too much debt.
Resource scarcity refers to scarcity of any type of energy, including oil, metals, water and arable land. The central argument concerns the mismatch between the supply of these finite resources and the demand from an increased population and improved living standards. Much of the increased demand is expected to come from China and India, the two most populous countries, whose economic growth has been rapidly expanding and is not expected to abate for many years. Although not typically mentioned in the same breath, Indonesia is another country where these same characteristics are increasingly evident. While technological improvements may help meet increasing demands for energy, arable land and water have no easy substitutes. The key question is whether balance will be achieved through price spikes or rationing. The fear of running out of “stuff” would be bad for economies and markets.
Infrastructure failure refers to the risk posed by the dependence of modern economies on computer networks and power grids. The cost of such a failure would increase exponentially the longer the networks remained unable to operate. We saw this with the power outage of August 2003, the ice storm in 1998, the BlackBerry network failure in October this year and the early snowstorm in the northeastern U.S. last week, where many businesses and families had to relocate until power could be restored. The wide use of technology means that all critical infrastructure networks—whether power plants or financial clearing systems—are vulnerable to security breaches and cyber attacks. While electricity was restored to those in the northeast within a week, prolonged disruption could lead to social unrest and criminal acts as people strive to survive.
A few words about the potential breakup of the eurozone, one of our original 15 extreme risks: the tensions between euro member countries—including those with current account deficits that would prefer a lower euro exchange rate—renders the breakup of the euro a real possibility. Leaving the eurozone, as is being suggested to Greece, would entail defaults on contracts and the re-denomination of debts. We have already begun to see this with debt holders being asked to accept 50 cents for every dollar of Greek debt. Investors’ bigger fear is that Italy, Portugal and Spain, whose own positions remain tenuous, may not be far behind.
While gold or other real assets provide a natural hedge for some extreme risks (e.g., currency crises, hyperinflation), many do not have a natural hedge. Therefore, it is important to adapt and maintain flexible decision-making systems. As Charles Darwin said, “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.”