Where risk hides

All the financial indicators are telling us that the markets are practically risk free, says James Ferguson, but they are not. In fact, risk levels are higher than ever.

If you look at the financial markets, you might think that the world is a fairly safe place. Equity volatility is at historical lows, no one is much bothered about saving for a rainy day (saving rates in the West are at historical lows), everyone seems to be assuming that inflation has been vanquished forever and the spreads between emerging market corporate bonds and those in the developed market are extremely low (suggesting that investors see little risk of financial troubles in emerging markets). But is this complacency about risk misplaced? Increasing numbers of analysts are beginning to think so.

Earlier this year, historian Niall Ferguson wrote an article for Foreign Affairs called Sinking Globalisation', in which he posited the notion that the current global environment is strikingly and frighteningly similar to the period immediately leading up to World War I. But it is not just the occasional academic who has begun to wonder if the relative peace in today's global economy is the calm before the storm. Some think that the situation today offers echoes of the one that led to the deflation of the 1930s. And a few weeks ago, the Bank of International Settlements (BIS) included a lengthy section, titled Dj vu', in its annual report, which explored the parallels between the current situation and that, not of 90 years ago, but of three decades ago. Being economists rather than historians, the men from the BISput the risks of political instability to one side and considered the resemblance to the 1970s when the so-called Go-Go years gave way to economic misery.

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So here's the question: are we politically reliving the particularly nasty era ofour great grandparents, or charting an economic course that last timeround led to rampant inflation, the stagnation around the time of the three-day week and the misery of the strikes and power cuts during the winter of discontent? Or both? Or neither?

The case for 1914

First, let's look more closely at Niall Ferguson's argument: that the current age of globalisation could come to a very nasty end, one that we simply aren't prepared for. Ferguson notes that although there had been (as ever) a few doom-mongers ahead of the outbreak of war in 1914, "most investors were completely off guard" when the crisis came. Just as is the case now, equity volatility was low and falling; bond yields and inflation expectations were low, despite rising commodity prices; and with global trade on the rise, few could imagine the possibility of a world war. Not until the last week of July 1914 was there a desperate dash for liquidity as it dawned on the markets that war was not just possible, but certain; the selling happened so suddenly, and on such a large scale, that the world's major stockmarkets "closed for the rest of the year". So what caused this unexpected crisis?

Ferguson suggests that "five factors can be seen to have precipitated the global explosion of 1914-1918". And guess what? All five have close parallels to today. I'm not convinced by all of them. Ferguson admits that his second and third points aren't very strong and that his case depends on his last two parallels, the validity of both of which I imagine historians could argue about for months on end.

It seems to me that, all in all, if history is going to echo itself, it probably won't echo 1914 particularly precisely. But that doesn't take away from the basic point Ferguson is making: that the world is much riskier than one likes to think. Whether the dangers he points to parallel those in 1914 or not, they certainly exist. But what can we do about the risk of huge global conflict? As Ferguson concludes, "the opportunity cost of liquidating our portfolios and inhabiting a subterranean bunker looks too high, even if Armageddon could come tomorrow [and] in that sense, we seem no better prepared than were the last beneficiaries of the last age of globalisation, 90 years ago."

The case for the 1970s

So if today isn't much like 1914, perhaps it is like the 1970s? The BIS case for history repeating itself is predicated on identifying the six factors that contributed to the build-up of inflationary pressures in the 1960s and early 1970s and looking for their parallels today. These prima facie similarities include "prolonged accommodative monetary policy, uncertainty about the degree of economic slack, concerns about the US external position and the implications for exchange rates, a sharp rise in oil and commodity prices and a relaxation of fiscal discipline". Basically, it comes down to the question: do these six parallels mean inflation is likely to flare up again, as it did in the 1970s, and if so, might the authorities again react too slowly?

1. Monetary policy

Between 1965 and 1970, average real interest rates for the ten largest economies in the world were in the 1%-2% range, and from 1971 to 1976, they were essentially zero or even negative. Money-supply growth was equally accommodative, growing at around 10% in the early period and above 10% for the latter years. Real policy rates have been persistently near, or below, zero in only one other period in the last 40 years, and that has been in the last three years.

2. Foreign exchange intervention

After the Bretton Woods system (which kept everyone on the gold standard) collapsed in 1971, other countries were no longer forced to accept the inflation that the US had effectively been exporting round the world by letting their currencies appreciate. "But in practice, they often chose to resist exchange-rate appreciation." Here, the parallels with today are stark. Asian central banks have bought huge quantities of US Treasuries, keeping their currencies down against the dollar, but also keeping US long rates down. The BIS reckons this "resistance to dollar depreciation has contributed to the rapid expansion of global liquidity".

3. Flat Phillips Curve

The Phillips Curve is the name given to the chart showing the trade-off between growth and inflation. The faster you stimulate growth, the theory goes, the higher the risk it will lead to inflation unless there's a lot of slack (unused capacity) in the economy. In the 1960s, the curve appeared to flatten, meaning policymakers thought they could stimulate the economy without fear of stirring up inflation. Clearly, they were wrong about that, and so it is with no little trepidation that the BIS notes that the Phillips Curve is once again looking flat this time even flatter than before.

Of course, one reason why inflation may not appear resurgent right now is that the way it is measured has changed a lot. We have now joined the Americans in using the so-called hedonic pricing method'. This little beauty allows you to include any improvements in a product, such as a PC's memory, for example, and knock that off the price, even if the actual price of PCs is rising. Also, housing costs are measured using rents rather than house prices and in the States they now assume substitution, so if chicken prices go up, they assume people switch to eat more beef whether they do or not. If you still find your inflation measure rising, you can always junk it in favour of a lower measure, the way Gordon Brown did in December 2003 when he switched from the old RPI, which was looking dangerously high, to the CPI.

4. Output gap

Back in the 1960s and early 1970s, the output gap (the difference between what the economy was producing and what it theoretically could produce at full capacity) was perceived to be "wide and negative". In other words, policy makers believed the economy was operating well below potential and rising unemployment seemed to confirm this view a view that we now know unfortunately to have been very wrong. In fact, productivity growth had begun to decelerate. Today, again, debate rages about productivity measurement, especially in the States and especially surrounding the impact of computers in the workplace. If productivity growth isn't as robust as the statistics say it is, then global aggregate slack might not be as large as people like to think, and recent commodity-price movements could be more likely to trigger wider inflation.

5. Oil prices

The first oil crisis saw energy prices surge in 1973-1974 to much higher real levels even than those seen today. However, non-oil commodity prices (like gold) and residential real-estate prices also recorded new highs at this time. As the BIS report states, "this provides yet another interesting parallel with current house-price developments", especially since a lot of the move in house prices then pre-dated the oil crisis itself.&nbsp6. Expansionary fiscal policy

The last argument is the weakest. The BIS points out that governments' fiscal balances became negative in the 1970s and are doing so now. But not only is this clearly a perennial problem, but fiscal deficits only became an issue for the G10 after the early 1970s (ie, as a consequence of the inflation, not as a causal factor).

The BIS's own conclusion to all this is that "these parallels, while notable, do not necessarily augur an imminent return to the inflationary environment of the 1970s". I think that they are probably right on that at least. Note that there are at least two further inflationary suppressors at work today. Firstly, by managing expectations, manipulating inflationary data, lowering union power and facilitating worker migration, the impact of inflationary pressures on wages (what the BIS calls the second-round effect) has become considerably more muted than it once was. As a consequence, labour's share of GDP has fallen to near-record lows on both sides of the Atlantic. This doesn't mean workers won't demand higher wages, but it does mean that they haven't really started yet. Second, the enormous changes to global supply conditions that characterise globalisation have kept inflationary pressures at bay. Export penetration from Asia, and especially China, keeps not just product prices low, but wages too. Deregulation and free trade have also reinforced disinflationary pressures via stiffer price competition.

The case for a new crisisSo is there nothing really to worry about? Certainly not: 1914 and the 1970s may not be coming around again, but there are other things to worry about globally. Deflation, for example. The Fed has long been worried that if the current environment looks like any other, it is the run-up to the deflation and now 16-year long recession that has blighted Japan.

Ultra low rates

"A second unforeseen development," according to the BIS, "is the confluence of policy and market rates that seem to be well below levels consistent with long-run non-inflationary growth". In Fed studies, the most reliable indicator of recession is an inverted yield curve (when short-term rates are higher than long-term ones), which the States is in great danger of getting soon and which we in Britain have had for a while now. How can long-term rates be so low when they're about to threaten to go lower still? Only recession and deflation can possibly provide the answer.

Next consider the boom/bust nature of credit and asset prices. A coordinated bust in the global-housing boom (which is entirely possible) could well usher in massive deflationary pressures. This kind of deflation could provide new challenges that require new solutions.

Overall, it seems to me that the only real similarities between today and the examples of the past previously mentioned seem to be that they too were periods of extended, non-inflationary growth that ended up going horribly wrong. The only thing we can say with certainty is that, in the end, busts follow booms and that the policy response to this can only be haphazard at best.

In his 2004 book, The Misbehaviour of Markets, the mathematician Benoit Mandelbrot revealed the results of a lifetime of studying and modelling financial markets. His results should shock the world out of such complacency. He found that markets are turbulent; they proceed in bursts and pauses. Markets are also riskier than standard theories imagine. Thirdly, big moves in markets concentrate together, so if it's going to go wrong, it'll happen quickly, in leaps not glides. Lastly, Mandelbrot argues that while prices might never be forecastable, future volatility can be estimated. This is because markets can exhibit what mathematicians call dependence without correlation. Roughly speaking, that means that small moves, up or down, is more likely to be followed by more small moves, and likewise with big dramatic moves. This implies that markets can get ever quieter and less volatile right up to a big exogenous shock and then, after just one big move, the odds of further very big moves occurring in quick succession go up dramatically. Bad days in markets clump together.

So perhaps the thing to worry about is that the market doesn't seem worried enough. Stockmarket volatility has collapsed back to 1995 levels; emerging market and corporate bond spreads (the yield premium they have to offer over risk-free government debt) are a fifth of what they were after the 1998 Russian debt default; and bond yields haven't budged, despite soaring commodity prices; and Anglo-Saxon households have savings ratios of about zero. I bet in a few years there'll be a lot of people out there wishing they had saved a lot more. A crisis of some kind is probably coming.

Five things that make today look like 1914

1. Imperial overstretch

In 1914, Britain lacked the resources to build up an army capable of deterring Germany from staging a rival bid for power and influence. "As the world's policeman," says Niall Ferguson, "the UK's beat had simply become too big." Today, the US, "an empire in all but name," is overstretched. It already runs two huge deficits, one fiscal and the other in trade, and borrows 80% of the world's net savings to sustain its consumption.

2. Great power rivalry

Ferguson cites great power rivalry as a cause of catastrophe. Today, there is obviously an emerging rivalry between the great powers of China and the US, which manifests itself over such matters as Taiwan and control of the world's natural resources.

3. Unstable alliance system

The third fatal factor in 1914 was an unstable alliance system mainly between countries that didn't trust each other. "The associated insecurities encouraged risk-taking diplomacy", reckons Ferguson, including the fateful annexing of Bosnia by Austria-Hungary in 1908. With this in mind, Ferguson points to Nato's unclear purpose and the "profound changes in Europe".

4. Rogue regimes sponsoring terror

Gavrilo Princip, the young Bosnian Serb who assassinated the Archduke Franz Ferdinand in Sarajevo, acted for Serbia and Bosnia both of which wanted to remain independent nations. All of Europe chose sides in this divide. Vitally, however, Ferguson suggests, there were "shady links" between Princip's Young Bosnia group and the Serbian government, which had itself "come to power not long before in a bloody palace coup". Today, Iran, Syria and North Korea could all be considered to be "rogue regimes supporting terrorism."

5. Revolutionary terrorist group

Ferguson's final point is that "a revolutionary terrorist organisation, hostile to capitalism (the Bolsheviks), turned an international crisis into a backlash against the global free market". Ferguson sees al-Qaeda as similar to the Bolsheviks. "It is a big mistake," he says, "to think of al-Qaeda asIslamo-fascist'." Instead, they are more Islamo-Bolsheviks', committed to a reordering of the world along anti-capitalist lines. What if they were to get control of, say, Saudi Arabia, in the way that Lenin grabbed Russia in 1917?