The Bear's Lair: Tail risks are the ones to watch

http://www.prudentbear.com/2014/03/the-bears-lair-tail-risks-are-ones-to.html#.Ux57xs7ImSo

The Bear's Lair: Tail risks are the ones to watch
March 10, 2014 posted by Martin Hutchinson

In a piece "Dinosaur tail risks" published on Jan. 27, I discussed the various unlikely things that could go wrong with the world economy, mentioning well into the second page the faint possibility of a global war, since the global geopolitical system appeared as fragile as that governing before 1914.

Well, that didn't take long. While the risk of all-out war is still no more than modest, it has definitely emerged as a lot more than a "tail" of less than 1% probability that risk managers usually (but wrongly) ignore.

There is a clear lesson here, for investors, bankers and managers. Risks that are in clear view are analyzed to death, can be managed for, and very often don't eventuate. Conversely tail risks, not provided for in conventional risk modeling and not properly analyzed, are far more likely to cause havoc, although naturally we never know which individual risk will rise up and bite us.

To a great extent, tail risks can be reduced by good management. There was little risk of a major worldwide depression with accompanying collapse of asset prices under the pre-1914 Gold Standard, nor under the Paul Volcker tight-money regime of the 1980s. With real interest rates safely positive, there was little danger of asset prices spiraling into a speculative bubble, causing massive misallocation of investment. Only in the 1920s, when the global monetary system had been dislocated by world war and an accompanying pile-up of debt, did speculation rise to excessive levels in the U.S. economy. Even then, the Great Depression could have been avoided with competent monetary and fiscal management in the U.S., as occurred in Britain.