Is ‘risk management’ a hopeless cause?
25 Nov 09
Respected economist Lord Skidelsky is arguing that the current financial crisis not only proves that mainstream academics were wrong to trust the rationality of the market, but also that it shows that believing we can price, manage and control risk is a dangerous illusion
Robert Skidelsky wrote a three-volume biography of JM Keynes, one of the giants of economics in the 20th century, and this year he has written a fourth book: Keynes: The Return of the Master. Last night in Edinburgh he set out his arguments, at the RSA’s Angus Millar lecture.
In his latest work, Skidelsky argues that the near-collapse of the banking system in a largely self-inflicted crisis puts paid to the idea, espoused by the Chicago School economists and others, that markets are essentially rational and the best thing governments and regulators can do is to impose transparency and them let them get on with it.
Keynesianism took a beating in the 1970s and 1980s, especially the idea that with fiscal policy it’s possible for governments to spend their way out of a slump. Now it seems that it’s the turn of the monetarists to hang their heads, as the unrestrained, “self-correcting” market turns out to be a toxic phenomenon and governments turn to “quantitative easing” and other fiscal measures to save their economies from terminal decline.
That’s not all Skidelsky argues. He also warns against the view that the crisis resulted from “mispricing risk” – and therefore, the solution lies in better pricing of risk. For Skidelsky, this view is based on a misunderstanding of the nature of risk and uncertainty.
One of Keynes’ most important concepts, Skidelsky says, was “irreducible uncertainty”. This is the element in business and world affairs that simply cannot be predicted; events arising out systems that are so complex, that to assign a number or a percentage to them is almost meaningless. As Skidelsky puts it “economics is not like physics”. This kind of risk needs to be prepared for, but it cannot be managed out of existence, and it means that markets are fundamentally unstable, not self-correcting.
So what would Keynes have made of today’s problems, and what solutions would he propose? Skidelsky believes the efforts to revive economies around the world with low interest rates and hefty fiscal injections from government are the right way to go, and he condemns as “irresponsible” talk of slashing public spending while the slump is still with us.
Skidelsky also argues that irreducible uncertainty cannot be eliminated through clever pricing or even through careful regulation; so the only solution is to ensure that there are “firewalls” between those institutions that take risks in volatile markets and the others that we rely on to keep the economy going day to day. That means, he argued last night, a three way split of the banks into “deposit banks”, “building societies” and “investment banks”, the latter being the risk-takers that can be allowed to go bust.
It’s a radical stance, but the events of the last two or three years mean that the ideas of Keynes and his modern day followers deserve a fair hearing.