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  • An Evolving Global Risk Environment

    The designers at Mercer/Think have taken some of the top-line data from the World Economic Forum 's Global Risks 2013 report and put them into this helpful visualization. It serves as a nice entry point to the report, and also a good conversation starter. Take a look: The full size graphic is available here . And don't forget to read the full report, here .

  • World Economic Forum: Global Risk Report 2013

    The World Economic Forum 's annual report on top global risks is out. It is, as usual, an unsettling report. And as with last year's report, the top two risks from the World Economic Survey of business and policy leaders, in terms of likelihood, are severe income disparity and chronic fiscal imbalances . Major systemic financial failure and water supply crises remain the top risks in terms of impact. But it is interesting to look at how the top risks have changed over the last five years. From the report: This video offers a nice summary of the report and its focus on three core cases: You can access the full report here .

  • WSJ: How the Euro Survived

    There are still a few days of 2012 left, but it seems safe to say that reports of the euro's death, to paraphrase Mark Twain, "have been greatly exaggerated." The currency remains in tact, and all members of the Euro Zone are currently sticking with it. Wall Street Journal Brussels bureau chief Stephen Fidler gives credit to ECB president Mario Draghi for staying true to his word and keeping the euro going.

  • A Defense of 'Cuddly Capitalism' and Innovation in Nordic Countries

    At VoxEU , three Finnish economists respond to a recent paper in which the authors assert that "cuddly capitalist" countries like Finland and other Nordic economies, "free ride" off of "cut-throat" capitalist countries like the U.S. Not surprisingly, Niku Määttänen , Mika Maliranta , and Vesa Vihriälä see a different picture. First, they take issue with the idea that the U.S. economy is more innovative: As Acemoglu et al. (2012a, 2012b) stress, innovation requires risk-taking. In a very innovative economy, one would therefore expect to find intensive job creation and job destruction, as firms that are successful in innovative activities expand rapidly while others are forced to exit the market. The available data do not suggest that the US economy is unambiguously more dynamic than the Nordic economies (Bassanini and Marianna 2009, OECD 2004). In Denmark, worker reallocation is more intensive, and in Finland almost as intensive as in the US (Table 1). Moreover, time series from the US indicate a marked decline in job and worker flows since the late 1990s (Davis et al. 2012), whereas – at least in Finland – both flows have stayed intensive (Ilmakunnas and Maliranta 2011). The authors go on to challenge the assumption that there is less dynamism in Nordic countries like Finland, and make the case that these are actually highly innovative economies in which entrepreneurs are encouraged to take risks for some of the same reasons they might be described as "cuddly" countries: One explanation for Nordic good performance might be that they are better in mobilising human resources. While hours per capita are higher in the US, a larger share of the working age population is employed in the Nordics owing to more inclusive educational, social and employment policies. This may imply that talents are harvested better for gainful economic activity. A second explanation could be the rather determined public policies to promote innovation. A third explanation might be that the economic incentives for innovation in the Nordics, while weaker than in the US, are not miserable after all, at least not across the board. For instance, all Nordic countries have introduced dual income taxation, according to which capital incomes are taxed at a flat rate. This helps in motivating entrepreneurs, despite quite progressive taxes on earned income. Sweden has recently encouraged wealth accumulation by abolishing wealth and inheritance taxes altogether. A well-designed safety net may also work to promote risk-taking. In particular, unemployment insurance may help risk-taking entrepreneurs by making it is easier for them to hire workers (see Acemoglu and Shimer 2000). Read Are the Nordic countries really less innovative than the U.S.? here .

  • Why European Policymakers are Paying Close Attention to the 'Fiscal Cliff' in the U.S.

    The OECD's relatively positive economic outlook , released earlier this week, presented Europe's struggles as much more worrying for the potential of the global economy than the fiscal cliff threat in the U.S. But as Dow Jones 's Nick Hastings reports, the two are not totally unrelated. Should policymakers in the U.S. not come to some agreement, then Europe is likely to feel a lot of economic pain:

  • Potholes on the Road Toward Greater European Integration

    Leading German economist Hans-Werner Sinn counts himself among those post-war Europeans who saw a more unified Europe--"the idea of a United States of Europe"--as an ideal step toward lasting stability. But, writing at Project Syndicate , Sinn shares concern that some centralized European institutions, like the European Central Bank, are taking steps that build greater rifts, rather than unity, among member states. Perhaps the idea of a United States of Europe, the dream of post-war children like me, can never be realized. But I am not so sure. After all, deeper European integration and the creation of a single political system offer solid, practical advantages that do not require a common identity or language. These advantages include the right to move freely across borders, the free movement of goods and services, legal certainty for cross-border economic activities, Europe-wide transportation infrastructure, and, not least, common security arrangements. Banking regulation is the most topical area in which collective action makes sense. If banks are regulated at the national level, but do business internationally, national regulatory authorities have a permanent incentive to set lax standards to avoid driving business to other countries and to lure it from them instead. Regulatory competition thus degenerates into a race to the bottom, since the benefits of lax regulation translate into profits at home, while the losses lie with bank creditors around the world. There are many similar examples from the fields of standards, competition policy, and taxation that are applicable here. So, fundamental considerations speak for deeper European integration, extending even to the creation of a single European state. Comments making bodies not only provide services that are useful to everybody, but also may abuse their power to redistribute resources among the participating countries. Even democratic bodies are not immune to this danger. On the contrary, they make it possible for majorities to exploit minorities. To counter this threat, democratic bodies invariably need special rules to protect minorities, such as the requirement of qualified majority voting or unanimous decision-making. Read Europe's Path to Disunity here .

  • IMF Projects Lower Growth in World Economic Outlook

    IMF researchers seem to be adopting a more and more gloomy tone. And the latest World Economic Outlook reveals why. The IMF is now projecting 1.5 percent growth in advanced economies and 5.6 percent for emerging market and developing economies in 2013. That's down from six months ago, when the IMF projected 2.0 percent and 6.0 percent growth respectively. More generally, downside risks have increased and are considerable. The IMF staff’s fan chart, which uses financial and commodity market data and analyst forecasts to gauge risks––suggests that there is now a 1 in 6 chance of global growth falling below 2 percent, which would be consistent with a recession in advanced economies and low growth in emerging market and developing economies. Ultimately, however, the WEO forecast rests on critical policy action in the euro area and the United States, and it is very difficult to estimate the probability that this action will materialize. This juncture presents major difficulties for policymakers. In many advanced economies, injections of liquidity are having a positive impact on financial stability and output and employment, but the impact may be diminishing. Many governments have started in earnest to reduce excessive deficits, but because uncertainty is high, confidence is low, and financial sectors are weak, the significant fiscal achievements have been accompanied by disappointing growth or recessions. In emerging market and developing economies, policymakers are conscious of the need to rebuild fiscal and monetary policy space but are wondering how to calibrate policies in the face of major external downside risks. An effective policy response in the major advanced economies is the key to improving prospects and inspiring more confidence about the future. In the short term, the main tasks are to rule out the tail risk scenarios and adopt concrete plans to bring down public debt over the medium term. Here is a look at the IMF regional GDP growth trends: You can read the full report here . And watch a short video from the IMF explaining the growth projections of the October World Economic Outlook below:

  • 'Chronic Uncertainty' Slowing Business in Europe

    Humans do not handle uncertainty well. So Europe's struggles has a lot of us nervous, in large part because we are having a difficult time figuring out potential scenarios for positive resolution. Europe's businesses have been affected greatly by the uncertainty, according to John Thanassoulis , a lecturer in the Oxford University Economics Department. Thanassoulis has been looking at the impact of the Euro Crisis on businesses in Europe, and he finds they are suffering from a sort of economic inertia and are highly reluctant to take any risks. Thanassoulis shared his findings with The Economist 's Peter Collins :

  • Risk Aversion and Middle Managers

    When we think of companies as being risk averse, who do we think it setting that culture? We probably look to top executives. McKinsey analysts Tim Koller and Zane Williams , along with University of Sydney Business School professor Dan Lovallo , want to focus our attention on middle managers. They may not make the big decisions for a company. But they make a lot of smaller decisions. And there is a risk-reward calculation with those decisions as well. From McKinsey Quarterly: Much of the typical risk aversion related to smaller investments can be attributed to a combination of two well-documented behavioral biases. The first is loss aversion, a phenomenon in which people fear losses more than they value equivalent gains. The second is narrow framing, in which people weigh potential risks as if there were only a single potential outcome—akin to flipping a coin only once—instead of viewing them as part of a larger portfolio of outcomes—akin to flipping, say, 50 coins. Together, these two biases lead to a distinctive set of preferences outlined in Daniel Kahneman and Amos Tversky’s prospect theory, which was largely the basis for Kahneman’s 2002 Nobel Prize in Economics. Consider a simple example of a risk-averse manager5 weighing whether to invest $50 million today in a project that has an equal likelihood of returning either $100 million or $0 a year from now. If we were to ignore the time value of money, we would expect a risk-neutral manager to be indifferent to the project—because the potential gains are equal to the potential losses. If the upside were greater than $100 million, we would expect the same manager to make the investment. However, the upside would have to be almost $170 million to entice the typical risk-averse manager to make the investment. In other words, the upside would have to be about 70 percent larger in order for that manager to overcome his or her aversion to risk. But what if we were to pool these risks across multiple projects? If the same manager faced not 1 decision but 10, the story would change. The manager’s range of outcomes would no longer be an all-or-nothing matter of success or failure, but instead a matter of various combinations of outcomes—some more successful, some less. In this case, the same manager would be willing to invest if the upside were only $103 million, or only 2 to 3 percent above the risk-neutral point. In other words, pooling risks leads to a striking reduction in risk aversion. Read Overcoming a bias against risk here .

  • Paddy Hirsch Explains a Floating-Rate Note

    The Treasury Department is working on a new product: floating-rate notes. The notes should be available in about a year, and they are designed to provide a less risky option for investors. So what are they exactly? Paddy Hirsch explains at the Marketplace Whiteboard :

  • With Uncertainty at Home, European Businesses Look to U.S. Banks

    With uncertainty on the continent, European companies are looking westward for financial support. The Wall Street Journal 's Dana Cimilluca reports that European businesses are turning to U.S. banks for loans-- leveraged loans in particular . Cimilluca discusses this "unprecedented" rate of U.S. banks loaning to Europe with Nick Hastings :

  • Robert Shiller's Speech to Finance Graduates

    Tis the season of graduations, and Robert Shiller has some thoughts to share with newly minted graduates looking to work in the field of finance. One key theme: Shiller wants new entrants into the fields of banking, economics, and finance to consider themselves as fiscal stewards and not simply people out to make money for money's sake. From Project Syndicate : Those of you deciding to pursue careers as economists and finance scholars need to develop a better understanding of asset bubbles – and better ways to communicate this understanding to the finance profession and to the public. As much as Wall Street had a hand in the current crisis, it began as a broadly held belief that housing prices could not fall – a belief that fueled a full-blown social contagion. Learning how to spot such bubbles and deal with them before they infect entire economies will be a major challenge for the next generation of finance scholars. Equipped with sophisticated financial ideas ranging from the capital asset pricing model to intricate options-pricing formulas, you are certainly and justifiably interested in building materially rewarding careers. There is no shame in this, and your financial success will reflect to a large degree your effectiveness in producing strong results for the firms that employ you. But, however imperceptibly, the rewards for success on Wall Street, and in finance more generally, are changing, just as the definition of finance must change if is to reclaim its stature in society and the trust of citizens and leaders. Finance, at its best, does not merely manage risk, but also acts as the steward of society’s assets and an advocate of its deepest goals. Beyond compensation, the next generation of finance professionals will be paid its truest rewards in the satisfaction that comes with the gains made in democratizing finance – extending its benefits into corners of society where they are most needed. This is a new challenge for a new generation, and will require all of the imagination and skill that you can bring to bear. Read the full speech here .

  • The Risk of Diversification

    What is a business to do when it grows and grows and becomes a major player in its sector? Common wisdom says then it is time to diversify. The idea being that diversification limits risk because it spreads out the company across sectors. But McKinsey 's Joseph Cyriac , Tim Koller , and Jannick Thomsen challenge that thinking in an article at McKinsey Quarterly . They argue that diversification is too tricky--that the upside is overstated and the exposure to risk is not mitigated. Take a look: From the authors: The argument that diversification benefits shareholders by reducing volatility was never compelling. The rise of low-cost mutual funds underlined this point, since that made it easy even for small investors to diversify on their own. At an aggregate level, conglomerates have underperformed more focused companies both in the real economy (growth and returns on capital) and in the stock market. From 2002 to 2010, for example, the revenues of conglomerates grew by 6.3 percent a year; those of focused companies grew by 9.2 percent. Even adjusted for size differences, focused companies grew faster. They also expanded their returns on capital by three percentage points, while the ROCs of conglomerates fell by one percentage point. Finally, median total returns to shareholders (TRS) were 7.5 percent for conglomerates and 11.8 percent for focused companies. As usual, the median doesn’t tell the entire story: some conglomerates did outperform many focused companies. And while the median return from conglomerates is lower, the distribution’s shape tells an instructive story: the upside is chopped off, but not the downside (exhibit). Upside gains are limited because it’s unlikely that all of a diverse conglomerate’s businesses will outperform at the same time. The returns of units that do are dwarfed by underperformers and therefore probably won’t affect the entire conglomerate’s returns in a meaningful way. Moreover, conglomerates are usually made up of relatively mature businesses, well beyond the point where they would be likely to generate unexpected returns. But the downside isn’t limited, because the performance of the more mature businesses found in most conglomerates can fall a lot further than it can rise. Consider a simple mathematical example: if a business unit accounting for a third of a conglomerate’s value earns a 20 percent TRS while other units earn 10 percent, the weighted average will be about 14 percent. But if that unit’s TRS is negative 50 percent, the weighted average TRS will be dragged down to about 2 percent, even before other units are affected. In addition, the poor aggregate performance can affect the motivation of the entire company and how the company is perceived by customers, suppliers, and potential employees. Read Testing the limits of diversification here .

  • Can US Banking Policy Provide Lessons for Europe's Banks?

    At VoxEU , Mathias Hoffmann , of the University of Zurich, and Iryna Stewen , of the University of Mainz, argue that moves to separate banks along national lines could have the opposite effect of that desired by policy-makers. That is, Hoffman and Stewen argue for more integration, not less. They use a simple graph to illustrate the relationship between bank liberalization and uninsured risk. The blue line represents banks that had not been liberalized at the time of the recession. The red line represents banks that had been liberalized. Hoffman and Stewen: Interestingly, the co-movement between interstate risk-sharing and the US-wide business cycle started to weaken during the 1980s, which is the period during which banking liberalisation at the state level got into full swing (in fact, the correlation between the blue line and the red, dashed line in Figure 1 is -0.44 before 1984 and only -0.13 thereafter). We show that it is indeed the liberalisation of state bank branching restrictions that is responsible for this weakening. The role of banking liberalisation for risk-sharing is illustrated in Figure 2, which presents the extent of interstate risk-sharing that a state typically achieves in the years around a typical NBER business cycle trough. In Figure 2, we distinguish between two groups of states: Those that had already liberalised in a given recession (red dashed) and those that had not yet liberalised (blue solid line). The message is clear – for the states that had not liberalised, consumption risk–sharing with other states drops sharply (the fraction of unshared risk goes up in the picture) in a recession, only to recover to 'normal' levels a year after. For the states that have already liberalised during the recession, the extent of risk-sharing with the US as a whole remains stable. In the paper, we then also show that these improvements in risk-sharing overall are actually driven by better access to credit markets (and not some other channel of smoothing or risk-sharing). We believe that these results point towards an important benefit from banking liberalisation: Financial integration facilitates access to finance mainly when it is most urgently needed – during aggregate downturns. Read Recessions and small business access to credit: Lessons for Europe from interstate banking deregulation in the US here .

  • Derivative Holding Even More Centralized than in 2008

    If you subscribe to the idea that banks holding a lot of derivatives increases exposure to risk (see WaMu, Bear Stearns), and you hoped that after the events of 2008 that such exposure might be less centralized, then you will surely be disappointed, or concerned, with this chart from Tyler Durden of ZeroHedge : Durden writes: The latest quarterly report from the Office Of the Currency Comptroller is out and as usual it presents in a crisp, clear and very much glaring format the fact that the top 4 banks in the US now account for a massively disproportionate amount of the derivative risk in the financial system. Specifically, of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure (HSBC replaced Wells as the Top 5th bank, which at $3.9 trillion in derivative exposure is a distant place from #4 Goldman with $47.7 trillion). The top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure. As historically has been the case, the bulk of consolidated exposure is in Interest Rate swaps ($204.6 trillion), followed by FX ($26.5TR), CDS ($15.2 trillion), and Equity and Commodity with $1.6 and $1.4 trillion, respectively. And that's your definition of Too Big To Fail right there: the biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return. Durden goes on to say that he does not accept the notion that bilateral netting limits exposure. Read Five Banks Account For 96% Of The $250 Trillion In Outstanding US Derivative Exposure; Is Morgan Stanley Sitting On An FX Derivative Time Bomb? here . Hat tip to Washington Blog at The Big Picture .
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