European Banking System – Systemic Risk Accident?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Basic research is like shooting an arrow into the air and,

Where it lands, painting a target (Homer Adkins)

 

The euro is heading toward an abyss. The sovereign debt crisis is evolving into a full-fledged banking crisis with global consequences.  Nicholas Veron, of the Peterson Institute, has written a short-article on issues facing European banks   “Europe Must Change Course on Banks” (Dec. 19^th).

 

The crisis is evolving along multiple dimensions.  On the sovereign debt, Greece’s debt restructuring remains unresolved, and Italy and Spain face major refinancing needs in early 2012.  Eurozone countries may have to refinance between euro 1.2-1.5 trillion in 2012.   The Eurozone summit on December 9^th, fell short of delivering a true fiscal union, and raised tensions within the euro area and with the United Kingdom.  On the growth front, a possible deep and prolonged recession looms, especially as countries place emphasis on fiscal austerity.

 

The banking system is a crucial piece of the puzzle and epitomizes the contradictions of Europe’s experiment with monetary union.  Since 2007, the system has exhibited gaps in risk management, and massive supervisory failures in some countries.  The banks are exposed to an agency problem – they are under national control, but pose risks for the euro. To keep on favorable terms with local authorities, they are often buyers of last resort after failed auctions.  In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility, especially since they depend on wholesale money markets for funding.  CDS premiums remain elevated for European sovereign debt  

 

Political affirmation of the integrity of the euro area banking system does not require new treaties, but major resistance comes from, among others, individual banks fearing the loss of national privileges or protections.  However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities.  A euro-area-level banking policy framework that will transcend interdependences between banking and political structures at the national and local level is a necessary condition for the survival of the monetary union.

 

As the euro crisis continues to unfold, there is increasing risk that the crisis could move across the Atlantic.  The near-term conduit from the banking system through money markets, derivatives or some other under radar surprise.  A longer-term mechanism is through a severe credit contraction that could induce a global recession.

 

The problem for global banks, especially for European banks, is that Basel I and II encouraged banks to hold sovereign debt as risk-free.  Basel III imposes more capital requirements and it will require additional euro hundred billions of capital over that suggested by recent stress tests.  The question is how European banks can meet the new capital shortfalls without causing growth stagnation?

 

The immediate goal for European authorities is provide standardization of regulation across the Eurozone such as national interests do not subvert the euro.  Long-term European banks have to be recapitalized without causing a severe credit contraction.  It will require prudent central bank policy and cooperation between national regulators.  The failure to implement prudent reforms could result in a near-term freeze in bank funding or a global recession.  Neither outcome is provides a favorable target for a sustainable US recovery.

 

For more on this follow the link: http://www.piie.com/realtime/?p=2581

Four Hard Truths for 2011 – Risks for 2012

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

History is the science of things which are never repeated (P. Valery)

 

The year 2011 was supposed to be the year that broke the back of the global crisis.  However, the crisis is still with us as the North Atlantic banking part of the crisis morphed into the Eurozone crisis.  The persistence of the European sovereign debt crisis risks moving toward a full-blown banking crisis.  The impact of slower growth in the advanced countries now threatens emerging economies.  Olivier Blanchard, the chief IMF Economist, looks at some of these issues in a VOXEU communique called “Blanchard on 2011’s four hard truths” dated December 23^rd.

 

The global economy entered 2011 in a recovery mode, although weak and unbalanced.  However the issues appeared tractable: dealing with excessive US housing debt, adjustment of countries on the periphery of Europe, how to handle volatile capital flows to emerging markets and to improve financial sector regulation.  It was a long agenda, but appeared within reach.  As the year draws to a close, a number is issues remain unresolved: the recovery in many advanced countries is at a standstill, the implications of a potential breakup of the Eurozone and the possibilities that conditions could deteriorate.

 

The four main lessons that Blanchard sees: the global economy is in a state of self-fulfilling outcomes of pessimism or optimism with major macroeconomic implications.  The self-fulfilling attacks can lead to bank runs which reduce the distance between a sovereign debt crisis and a full-fledged banking crisis.  Government entities have provided liquidity to ensure market interest rates remain reasonable.  The main risks remain for banks in Europe and the rollover of sovereign debt.

 

Secondly, incomplete or partial policy measures can make things worse.  We have seen how perception got worse after high-level meetings in Europe promised a solution, but delivered only half without details.  The announcement was made with great fanfare, but turned out insufficient with potential obstacles.

 

Thirdly, financial investors are schizophrenic about fiscal consolidation and growth.  Investors react favorably to positive news on fiscal consolidation, but tend to ignore lower growth which can lead to increase, not a decrease, on risk spreads on government bonds.  Fiscal consolidation is required to reduce debt to prudent levels, but not to produce stagnation “slow and steady wins the race”.

 

Lastly, perception molds reality.  This was the case of conditions in Europe.  Once Italy was considered as a risk, the perception did not go away.  The concern about the viability of the European economy led to concerns about the possible breakup for the Eurozone.

 

If you put the four factors together, you can explain why entering into 2012 why macroeconomic risks have increased.  It will be harder for officials to put the recovery back on track than it was a year ago.  Fiscal consolidation is required without causing growth stagnation.  Central banks and governments will be required to provide liquidity as a backstop to prevent a bank runs and avoid multiple equilibria.  It will require plans not only announced, but implemented with full disclosure and effective collaboration among all involved.

 

We have to learn from our mistakes in 2011, otherwise 2012 is going to be a period of higher risks.  The alternative is just too unattractive.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7475

Step by Step Approach to Crisis Resolution

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSdsolutions.com

                                    

 

Politics is not the art of the possible.

It consists of choosing between

                                            The disastrous and the unpalatable 

                                                          (JKGalbraith)

Eurozone officials and politicians have adopted a mini step-by-step approach to crisis resolution.  This approach has back-fired as cost of crisis resolution has increased dramatically as the sovereign debt crisis is turning into a full blown banking crisis.  The European Central Bank (ECB) finally took a big step last week when they made nearly euro 500 billion in three-year low rate loans available to 500 banks across the region.  This comes ahead of a crucial time for policymakers as a large volume of sovereign and bank debt has to be refinanced in the first quarter of 2012.  The ECB has provided a near-term fix for the Eurozone crisis, but what has to be addressed longer-term?

 

Charles Goodhart & Dirk Schoenmaker in “The Political Endgame for the Euro Crisis” (VOXEU, Dec. 14^th) discuss some of these issues.  The euro crisis is deepening, as European leaders continue with their “too little too late” policy reforms.  Solving Eurozone problems requires a strong direction for fiscal and banking policy.  This in turn needs greater political integration through an elected president of the European Commission and a two-chamber parliament representing EU citizens and EU member states. 

 

The euro has a supranational monetary policy framework, while the fiscal side is still national or inter-governmental.  With political legitimacy, the President of the European Commission could: first, enforce budget discipline on participating members and restrict the impact of fiscal spending, and second oversee Eurozone banking supervision and resolution to foster banking system stability. 

 

One step is the establishment of a Eurozone Minister of Finance with power to enforce provisions of the Stability and Growth Pact on fiscal deficits.  A second step is a reform of the parliamentary side of the political union by establishing one chamber to address issues of the electorate and a second chamber to represent interests of the separate member countries.  This would allow a gradual transition of banking supervision and resolution from the national level toward a wider European scale.  The new Eurozone Finance Minister would need specific authority from the European Parliament to establish budgetary and banking powers and the European equivalent of the FDIC, SEC, etc. 

 

The resolution of the euro crisis needs both political reforms as well as a technocratic solution.  There are major issues that need to be addressed, but the min-step approach to financial crisis resolution or risk management has a cost – often a higher cost.

 

For more on this follow the link:

 www.voxeu.com/index.php?q=node/7420

 

 

Fast Company Creativity Issue

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I just finished the latest Fast Company issue, which was centered on creativity.  Creativity is not a word that you hear a lot about in risk management.  Neither is the term “Fast Company” for that matter.  Why is this?  Is this a good thing?

 

Exceptions

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

We have all heard the saying, “the exception that proves the rule”.  I have to admit that I have never really grasped the meaning of this statement, although I realize it is always said when there is a clear exception to a rule.

 

In risk we always have to deal with exceptions.  In fact I would argue that exceptions are the rule of risk management.  Without exceptions there would not be a field or an industry of risk management.  Without exceptions we would not have schools or degrees in risk management.  Without exceptions I would have to find something else to blog about.

 

The tough question of risk management however is how do we deal with exceptions.  How do our risk models incorporate exceptions?  The toughest question of all perhaps is deciding when to abandon the risk protocol for an exception – in essence deciding when an exception is exceptional (assuming that is not an oxymoron).

Backtesting

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Coming from a background in investments (and nuclear physics), we always talk about back-testing a new idea.  In other words, how would have the world unfolded (differently, better, worse) if we implemented (did not implement) a given strategy.  Back-testing however seems to be a rarity in the world of risk management (with the possible exception of financial risk management).  Perhaps this is a major oversight of the profession. 

 

I realize that back-testing operational or strategic risk is tricky.  A lot of assumptions need to be made, and models of outcomes need to be constructed.  Perhaps however it is the exercise of working through the necessary assumptions and constructing the models that would make it such a useful and valuable exercise.

ERM Course – I Need Your Help

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

I am putting together a new Enterprise Risk management Course for my MBA students.  I would love to hear suggestions from my readers as to what I should include.  Any suggestions you have for readings, papers, topic suggestions would be most welcomed. 

 

I have put together now four major ERM courses and this will be my 5^th version where I have started from scratch.  The one interesting thing about teaching ERM is that the field is still so young and still rapidly evolving that each new version allows for a fresh look at things.  I look forward to hearing your suggestions.

 

Steve Jobs as Risk Manager

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc

www.RSDsolutions.com

info@RSDsolutions.com 

 

Just finished the Steve Jobs biography.  Interesting book about an interesting person.  Not sure if it is a biography on how to be a manager (rip people apart, be ruthless, demand nothing but perfection, be a rebel, think differently, be obsessed with design, be obsessed) or how not to be a manager (see previous set of parentheses).  Interesting to think though about what Steve Jobs would be like as a risk manager.  Would his qualities be an asset, or a liability?  

Tebow Stats

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com 

info@RSDsolutions.com 

 

Like many of you I sat and watched with a sense of expectation as Tim Tebow played awful for three quarters against the Chicago Bears last weekend.  I kept watching the game in part because Tebow (and the Broncos in general) were playing in such a mediocre fashion.  We all know the script – Tebow sucks statistically for three quarters and then in the fourth quarter comes to life to impossibly pull the game out of the hat for a win for the Broncos.

 

I suspect that the dismal performance of the Broncos for three quarters, only to pull out the game after coming from behind is making Rolaids addicts out of the Broncos coaching staff and management.  The fans however seem to love it.  The only stat that fans know about in the final analysis is who won.  The vast majority of fans are not at all concerned with how the win occurs.  A win is a win.  Stats are simply things to debate in the off-season when there is nothing else to talk about.  Broadcasters, coaches and managers seem to be the only ones concerned about performance statistics.

 

Now shifting back to risk management, which they tell me is supposed to be the purpose of my rambling – but thankfully short – blogs.  Are risk managers more concerned about stats (i.e. VAR, risk weightings, volatility levels etc.) or are we more concerned with outcomes?  The answer should be obvious, but I am not sure that it is.  In my working with risk managers, they often seem more concerned that their numbers look good, and less concerned about the actual outcome (assuming of course that the numbers looked good beforehand).  Perhaps risk managers should be more like the fans and more concerned about outcomes. 

 

Sometimes the numbers suck, but the desired result occurs.  Sometimes the numbers are great but the outcome sucks.  Sometimes uncertainty occurs.  (Did I say “sometimes” in the previous sentence – I meant “always”.)  Stats are stats, and wins are wins.  Sometimes (always) it really is that simple.

 

Risk Genius

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc

www.RSDsolutions.com

info@RSDsolutions.com 

 

Genius has many definitions.  Genius is often thought of at performing at a superb level of intelligence.  However genius was once described to me in this fashion; someone who thinks superbly has a superb intelligence, a genius however thinks differently.  A genius is not more and faster intelligence.  Genius is a different kind of intelligence.

 

It is my opinion that the risk industry (and in particular in the financial sector) has a lot of extremely intelligent people.  However there are few, if any geniuses at work.  A group of really intelligent people are like a group of lemmings – except they are really efficient and quick lemmings – they get to a higher cliff, much quicker than more ordinary mortals.

 

Risk (and in particular, financial risk) needs some geniuses.  

Trouble in Paradise

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

                                                                  There’s trouble in paradise

                                                                  And Heaven’s not the same,

 

These are lyrics from a doo-wop song by the Crests that can be applied to risk management and stop-gap measures proposed by Eurozone officials to stabilize financial markets.  This can describe the Brussels deal last week that attempts to reformulate the underlying rules for the euro zone.  The problem is that the full details were not disclosed and already it is falling short of market expectations.

 

There are a number of unresolved issues from the meeting:  there are no details on how much money will be needed to protect the market from further speculative attacks and prevent contagion, how will the banks be recapitalized to cover losses on their sovereign debt holdings, there is limited information on what measures will be implemented to reduce the borrowing costs and does the cure proposed in Brussels actually work?

 

The amount of European debt that needs to rollover in the next 12-24 months is staggering compared to the amounts discussed for a temporary financing facility.  The outstanding sovereign debt of Italy is nearly $3 trillion that would dwarf any temporary financing facility being considered.  A rating down-grade could spark another speculative attack.

 

The recent stress tests for the European banks suggest a further need for $150 - $200 billion in new capital.  This does not take into account any further write-offs of existing debt.  In addition, the banks are often under intense pressure in their country of domicile to take on additional sovereign debt after poor auctions.   If the sovereign debt crisis moves into a full blown banking crisis, the speed of contagion will increase rapidly.

 

The borrowing costs of a number of countries have increased to near-record levels in recent auctions.  The issue of borrowings costs has not been adequately addressed and may not be reduced until financial markets are stabilized.  Details of how this is being implemented are lacking.

 

There have been a number of measures proposed to promote fiscal discipline, central oversight by Eurozone authorities and rules to discipline countries that break the debt limits.  The idea is that once these rules are in place, the ECB and Eurozone officials could do more to resolve the underlying problems.  However, this is rehashing old issues that were in the earlier treaty and raise issues about national sovereignty.  There is some doubt that all countries will accept the proposed changes.

 

There is another issue not addressed by authorities and that is the persistence of imbalances and the lack of economic growth.  A number of countries are experiencing problems from lack of growth and not budget management.  There is concern that fiscal austerity will blunt growth and actually worsen the debt problem.  Eurozone officials need to consider lessons from the 1930s and not just the 1990s.

 

The ECB needs to take a more active role in ring-fencing the crisis and act as a lender of last-resort (such as debt purchases in the secondary market).  Officials need to provide a larger financing facility to deal with the crisis.  Otherwise, there will be further trouble in paradise.      

The Cost of ECB Inaction as Lender of Last Resort

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The recent newspaper headlines have included such items as “S&P Warns on 15 Euro-Zone Nations”.  Other topics include the size of a temporary bailout fund may rise to $1.0-2.0 trillion to stabilize financial markets and the European banks may eventually need $150-200 billion of new capital to offset potential losses on their holdings of sovereign debt.  The point is that the cost of stabilizing financial markets has risen dramatically – it might help to understand why policymakers delay decisions and provide some lessons for risk management.  A recent communique “Why the ECB refuses to be a Lender of Last Resort” (VOXEU, Paul de Grauwe, Nov. 28^th) looks at some of these issues.

 

The euro is under intense pressure, as it has a number of weeks to save itself, as a number of institutions prepare for a potential restructuring or its actual demise.  Analysts are calling for the ECB to act as lender of last resort for the Eurozone bond market.  Why does the ECB hesitate to act as a lender of last resort?  If a central bank is to do so, it must evaluate the costs and benefits of its inaction of not providing last resort buying service.

 

The cost of inaction arises from the risk that inaction will lead to a collapse of the banking system.  The benefit of inaction is the avoidance of future moral hazard risk which is beneficial to long-run the banking system stability.  When evaluating the cost and benefit, the time horizon which these costs and benefits materialize matters a great deal.  The cost of not providing lender-of-last-resort is almost instantaneous, since bank liabilities are short-term.  The results of inaction are likely to be realized quickly while the benefits will be realized sometime in the future, possibly far in the future.

 

The asymmetry of the timing costs and benefits helps explain central bank behavior.  Viewing the government bond markets, the sovereign debt crises occur at a much slower pace than banking crises.  When facing a sovereign debt crisis, the conservative central bank view will weigh the long-term importance of reducing moral hazard unless the banking system is in immediate danger of collapse.  

 

The implication is ECB inaction unless the cost is immediate and clear and the sovereign debt crisis leads to an immediate banking crisis.  The implication of ECB caution suggests two results:  this means the amount of the liquidity/aid the ECB eventually may have to inject into the banking system is likely to be far higher than the amount required to stabilize government bond markets and a banking crisis will also trigger a deep and long-lasting Eurozone recession.

The ECB may well be behaving rationally, but it is both foolish and dangerous. The lessons for risk management – address potential risks or pay the consequences. 

 

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7352 

 

Tailors

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I was conducting a class last week when we starting discussing a quote attributed to Einstein that “Elegance is for tailors”.  The meaning that I take from this is that as scientists (and as risk managers I consider us to be scientists – although what science(s) we should be is a great topic for a future blog) should be most concerned with the functional and what works, rather than what is mathematically elegant.

 

There is a lot of finance and risk management that is elegant.  The problem is that a lot of it is wrong.  It assumes conditions that are only approximately correct (I blogged before on quasi-arbitrage), and thus when scaled up to industrial size the mistakes become huge, rendering the original elegant result not only wrong but misleadingly wrong.

 

An old saying that I first saw attributed to Riskmetrics rephrases Einstein’s saying as; “It is better to be approximately right, than precisely wrong”.  Let’s leave the tailoring to the tailors.  (Unfortunately great tailors are a dying breed.)

Old Favourites

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

I am writing this blog late on a Sunday night as I wait for a connecting flight to get home from an international trip.  I am tired, exasperated with the hassles of travel, and hungry yet not wanting to face another airport meal.  Those of you that travel a lot know the drill all too well.  (The flip side is that I have a really cool job as a consultant, and I get to meet a lot on interesting people who give me great ideas and inspire me.)

 

While I sit in the airport lounge and think of all the things I have to do, I am reminded for some strange reason of my university days.  It must be the Sunday night fatigue, and combined with the time of year of the semester end with all of its stresses with exams and term projects coming due.  In any case, I am tired, but have a long layover, and thus I need to get myself to some level of reasonable work efficiency.

 

Thinking of my university days, I thought I would pick out an old album that I used to listen to while I did my university work.  In my university days I always had energy (youth is an amazing thing) and somehow I always got things done. Perhaps instead of the youth it was the music?!  At this stage it can’t hurt I thought.  I cued up an old university album on my iPad and you know what – the music did revive me, and I am now starting to have a productive evening again.

 

Listening to an old album inspires old feelings – most of which were good feelings.  Indeed the music is inspiring me and I am being quite productive.  However it got me wondering if as risk managers we too go back to the old tried and true when creativity and energy for new solutions is lacking.  Old favorites are great for a short spurt, but do we want to constantly and consistently live in the past?  Or is the old music and the old way of doing things invigorating because it was great and continues to be great?  An interesting double sided coin.

Why

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

As a kid I was a royal pain (some – maybe most – of the people who know me now might say that not a lot has changed).  I was always asking my parents why this and why that.  Everything was one big question to me.  Fortunately my parents were patient and answered my questions and then when fatigue set in they would send me to the bookstore.  My addiction with questions is probably what led me into studying science at school.

 

Kids in general tend to be very curious.  They ask lots of questions, and they ask lots of layers of questions. Kids think their parents are smart, as their parents (and teachers) have answers.  It is fun being a kid – ask a question and get an answer.  Now as a parent I realize that sometimes the answers were not quite as accurate and true as I originally thought. 

 

Do we as risk mangers ask lots of questions – or do we try to play the role of grownups in always having an answer (no matter how flimsy or inaccurate)?  Count how many times today you ask why, and how many times you give an answer to someone else’s question (implied or explicit).  What is your question to answer ratio?  Are you a parent or a kid?  Which should you be as a risk manager?

“Bad Recipe” for Risk Management – The Agency Problem

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The Wall Street Journal of November 23, 2011, focusing on the demise of MF Financial, noted flaws in their risk management – the lack of accountability for decisions.  The article noted that decisions made by MF Financial CEO Jon Corzine, on his European sovereign debt trades of $6.3 billion, lacked proper supervision.  The typical trader would have position limits and require approvals from the head trader, the risk manager, chief risk officer, the CEO and eventual approval by the Board of Directors.  In the case of Mr. Corzine, it was only the Board of Directors, and most likely, reviewed well after the positions were established or sometimes called the agency problem (conflict on incentives).  The failure to implement an effective risk management system resulted in the demise of MF Financial.

 

The US bi-partisan Super Committee on deficit reduction failed to reach an agreement by the November 23, 2011 deadline imposed by Congress.  The lack of a clear outcome and responsibility by politicians pose a special problem for risk management – the agency problem.  The agency problem, or sometimes referred to the agency dilemma, attempts to address difficulties that may occur under periods of incomplete or asymmetric information when a principal (voter) hires an agent (congressmen), to address a problem of moral hazard (weak economy) with a potential conflict of interest.  The problem is when the agent (congressmen) acts for their own self-interest rather than that of the principal’s interest (restoring economic growth).  A recent example is the no-tax pledge made by Congressmen to Grover Norquist, of the lobbying group “Taxpayer Protection Pledge”.  Mr. Norquist does not have any accountability to voters on the economy.     

 

As a result, a number of automatic spending cuts are supposed to kick-in 2013.  The nastiness of the cuts and their potential implications were expected to encourage lawmakers to strike a deal.  It now appears that Congressional leaders will be unable to reach a compromise as special interest groups try to limit/offset the impact of mandatory spending cuts implemented in 2013.  The question becomes how long will this impasse persist?  It could last until the election looming in November of 2012.

 

Under the current incentive system, US Congressmen have little incentive to reach a compromise to tackle the debt problem and adopt policies to restore economic growth.  It was noted in an earlier column in VOXEU on November 23, 2011 that the surge in political uncertainty comes at a cost. A recent note Policy uncertainty and the stalled recovery (Scott Baker, Nicholas Bloom & Steve Davis, VOXEU, October 22nd) address these issues.  The authors distinguish between economic uncertainty and economic policy uncertainty, constructing an index to measure policy-related uncertainty and argue that reducing policy uncertainty would raise output and add dramatically to job creation.  The authors noted that if their index for policy uncertainty was restored to 2006 levels, it could result in a rise of industrial production by 4% and the creation of 2.5 million jobs over 18 months.  This may not be enough to create a booming economy, but it is a step in the right direction.

 

The lack of clear accountability of Congress (agent) to the voter (principal) will likely result in a stagnant economy through 2012.  The failure to implement an effective risk management system for politicians has a cost for the US economy.  Politicians need to learn the lessons on risk management from MF Financial.

 

A reference for the Baker, Bloom & Davis paper.

www.voxeu.org/index.php?q=node/7137