Known Unknowns


Welcome to Known Unknowns, a newsletter about risk and uncertainty, in a world where everyone is a risk manager now.

Future of risk

I was asked to write an essay about the future of risk-taking, both in terms of investing and in life in general. Right now, pretty much every prediction about the future that we make today will surely be wrong. But I’m not buying the idea that we’ll never be the same again. Long-term, I think we will go back to normal. Taking risks comes with the potential for an upside, both in life and in markets. And when downside risks seem more remote, we tend to forget that they’re there at all.

Barely ten years after the financial crisis, people were piling into risky assets, giving up on tail risk protection, and firms were loading up on leverage. Odds are that years (or even months) from now, we’ll be equally forgetful about the inherent risks in markets. True, children of the Depression were more risk-shy, but that’s because the Depression dragged on for many years, and markets took a very long time to recover. That could happen today, too. But odds are that it won’t. We have better policy, and we are richer as a nation—which means that we can lessen the severity of the economic impact, assuming that this doesn’t go on for years.

And in life, in general, there is always a risk to large gatherings, to traveling, to living your life outside of your home. Those risks are much greater now, and also pose negative externalities to others. But as they fade from our minds, we will gather again, simply because it feels good.

I think that some things will be different, though. Masks won’t look so weird anymore, and we’ll be quicker to act with regards to future potential pandemics, because we now know how bad they can be. I know we were warned about virus risk for years, but until it happened in Italy, most people in Western countries couldn’t imagine that it could ever really happen here. Now we can.

In the shorter to medium term, though, our behavior will be more erratic. Markets will be volatile as they digest good news, and then bad news. Investors must live with volatility again.

Even before COVID, we had become anxious as a culture, and now everyone is going to have to live with elevated risk and make complex risk calculations. We got the message to stay in our homes until it’s safe to reemerge. But it may not be safe for a very long time, and yet life will have to go on. People are going to have to start taking managed risks, and there will be no guarantees about the outcomes. We aren’t used to that. Past civilizations lived with elevated risks (even worse than this!), but we don’t know how anymore. The good news is that as we get more data, the risks will be easier to manage. We’ll know whether or not outdoor activities, while always riskier than being at home, are low-risk enough to justify the upside of benefits to our mental health and well-being.

I go back and forth on the future of data and risk modeling. Data is our way out of this in the near future (or until antivirals and a vaccine come along, and even those may just make the situation less risky, not completely risk-free). Policymakers use that data in order to make risk estimates to re-open the economy and when to pull back. Individuals will need to make sense of data and projections to guide their own behavior, like whether or not to go to the gym.

Andy Lo points out that the stock market was less volatile during the 1918 pandemic because the government was less forthcoming with data (or they didn't have it). There was also a much quicker recovery than what we're in store for. When data tells us something awful or is incomplete it creates the chaos and destruction we have now. But of course, a lot more people died from the Spanish Flu. In the long run we'll be better off with the more data and risk models (and a better understanding of infection disease).

This could be a great time for risk measurement. Everyone is speaking my language these days. Alternatively, everyone is also seeing how imperfect risk models are. They are estimates of an uncertain and ever-changing world and human behavior, and they’ve had to rely on lousy data. I’m sympathetic to the epidemiologists whose models are falling short, as they just doing their best with the data that is available to them. Mistakes will be made, and models will be misused, just like they are in finance. I hope that doesn’t make people distrustful of risk estimates, because as bad as they are, they’re all we’ve got.

We all need to learn to live with ambiguity, and that’s not good for anyone—especially anxious people.

Living with tail risk and uncertainty

John Kay and Mervyn King have a new book out on Radical Uncertainty, risks that we never imagined, or at least always assumed to be unlikely. The only way to manage uncertainty is through flexibility and resilience. Shocks will always happen that we can’t predict.

I interviewed General HR McMaster for my book regarding how he managed uncertainty in wartime, and he made the same argument. You have to be prepared to change plans on the battlefield when circumstances change, because they always will.

The problem is that flexibility is expensive. In warfare, it means a larger, better-trained military. In markets, it means more cash and less leverage, which is great when you need it, but in boom times it becomes a disadvantage. More global trade meant more growth and cheaper prices. But it also meant more tail risk, and it made us less resilient now that we need to get drugs and PPE from other countries. But 99% of the time, we like more growth and cheaper prices.

It’s easy to say that we should be more resilient. But I wonder if we’re willing to pay the price when our memories fade. If we do want to make more goods in America, how can we make that sustainable when the economy comes back? Will it take government subsidies or tariffs, even if that means less growth?

The question that we need to ask as the world returns to normal is how we can create incentives to build resilience in good times, without creating distortions that do more harm than good.

Radical economic ideas are still bad ideas

The cost of resilience is the big question going forward, but this is not the conversation happening right now. Instead, people are arguing whether the existence of tail risk is evidence that we need radical economic policies in good times, too—things like Universal Basic Income, Modern Monetary Theory, or the end of capitalism.

But people arguing for radical economic policies don’t seem to understand risk. Downside protection is not socialism. We pay taxes so that the government can be the insurer of last resort—taxes are sort of like insurance premiums. An insurance company doesn’t take over the rest of your life just because you file a claim. They help you out when you need it, and then they step out of the way.

And a one-time payment to almost every American is not UBI, which is by definition a stable income floor that you can count on in good times or bad.

We are also not monetizing debt. I mean, we kind of are, because the Fed is buying lots of debt while the Treasury is issuing it. But without a commitment to keep doing it, in good times or bad, it’s still not monetization. Besides the fact that the Fed pays interest on reserves means that it’s not monetized, which is a technical—but critical—loophole.

When you study economics, you learn a lot of different theories about how the economy works. These theories all make different predictions and offer different policy prescriptions. Eventually, you come to terms with the fact that all of these ideas are kind of right some of the time, depending on the nature of the problem and the state of the economy. But the better theories are robust to many different markets, economic shocks, booms, and busts.

Nothing about the state that we’re currently in vindicates radical economic ideas—not even as a tool to fight recession.

Small Businesses

I worry about how small businesses will fare. A bad economic shock tends to accelerate existing trends. Manufacturing employment tends to fall a lot during recessions, and never recovers, because those jobs were precarious to begin with. And now small businesses are very vulnerable. The super-star economy, which reflected structural changes to the economy, already made it difficult for small upstarts (or small existing businesses) to survive, while bigger businesses thrive—for example, a small mom-and-pop hardware store that can’t compete with Home Depot.

Even if we give small businesses loans or grants during the shutdown, it still won’t help them when they need to re-open at half capacity. Many small businesses have thin margins even in good times, and they simply can’t survive with less revenue.

It seems like many small businesses will fail, and larger firms, with multiple locations and higher productivity, will be at a huge advantage as the economy slowly reopens.

As we get into the recovery phase, we need to think harder about why big firms do better in this economy—good and bad—and what space small employers might occupy within it.

In other news

States can’t declare bankruptcy, but it could be a gift to Illinois if they could. Though there are other, better options.

Ned Phelps on the nature of unemployment.

Until next time, Pension Geeks!