International Fund Strategies
London, December 1997

What do you understand by the term 'risk'?

It is linked with foresight, and that's what futurists try to do. I look at the future as partly determined by things that human beings can't control, and partly the result of decisions humans make about things they can control. With enough information and using probability theory, they may be able to avoid the risks associated with the controllable, and ameliorate the effects of the uncontrollable. I gave a paper in 1978 to the North American Risk Assessment Association, pointing out that the probability theories and models they were using in the insurance industry were very questionable and would probably get them into real trouble. Back then, my concern was that there was a deep assumption in probability models that the greater the magnitude of the risk, the less the likelihood of its occurrence. This overlooks the fact that human being are filling the probability space with a lot of very risky stuff! My friend Buckminster Fuller put this assumption down to 'folklore' -- volcanoes don't happen very often. That was my introduction to the way the insurance industry calculates risk and, at the time, I predicted that a lot of insurance companies would go belly up, particularly those like Lloyds.

In your writing, you distinguish between 'markets' and 'commons' -- could you briefly explain the difference?

I was trying to show how economists and systems people look at these two different kinds of systems very differently. Economists look at markets in terms of individual systems of decision-making, where the aggregate of individual decisions make the price data. Those systems run on competition, the 'rational economic man' model, the invisible hand, maximising self-interest and so forth. Then the only way they can deal with a commons is by turning it into the property of all.In dealing with common resources, which is now the name of the game, they say "we can only take care of resources if somebody owns them." They try to figure out how to privatise them, for example by divvying out rights to fish stocks, but this doesn't deal with anything or anyone outside the money economy. System theorists or futurists simply say that a market is an open system with divisible use of resources -- anyone can go in and use resources, and they run on 'win-lose' rules.Commons, on the other hand are indivisible resources, such as the air we breath. When you have indivisible resources that everybody may need but which can't be owned by anyone, you must have 'win-win' rules to make them operate equitably and efficiently. One is a competitive system, and one is a co-operative one.A good example is the weather -- the only way to control emissions of greenhouse gases is with co-operative rules like the Climate Convention. The only question is how those rules will be set, and how responsibility will be apportioned.

How does the risk profile of a commons differ from that of a market?

In my view, it is always higher, because it requires this difficult collective political co-operation to protect it. So commons are subject to the 'tragedy of the commons' where, for example, every farmer thinks he can graze a few more sheep on the common land, until it is over-grazed and destroyed for everybody. Because nobody own them, everybody over-uses them.

What do you perceive is the relationship between risk and time-horizon?
Does this differ between markets and commons?

The further out in time you go, the greater the uncertainty. The difference here is that in markets, you generally get more rapid feedback about the risks you create, whether through other players saying "Hey! You're putting me at risk," and the insurance industry can get in there, etc. The problem is that markets can externalize risks into the public commons -- most of the GNP growth of the last quarter-century has been at the cost of externalizing environmental and social problems, and the feedback loops are often very long. These are 'ticking time-bomb' risks, which no insurance company will find in their interests to cover, or even necessarily find the clients who want them to, so you get into crisis management, and taypayers end up as 'insurers of last resort.’ That’s what is happening now in Kyoto. Finally, in 1993, Swiss Re asked "Why are we covering all these weather related disasters when the scientists are telling us that crazy weather will be the first clear manifestation of global warming?" So the report said "We're out of here!" This has now produced the dialogue they are having on the portfolio side saying "Why are we up to our eyeballs in carbon-based economy stocks, where we should be shifting to renewable noncarbon-based investments, in our own self-interests?" That's a long loop and a intricate argument. The problem with executives in most companies is that they always have so much in their in-boxes, there are very few who have time to sit back and say " Ok, let's take a wide shot and see what's coming over the horizon."

While models based on Modern Portfolio Theory assume that specific risk and systematic risk are independent, you maintain that the aggregate of individuals' self-interested actions greatly increases risk in the whole system -- what is the basis of this?

Almost no portfolio theory that I know of really looks at systematic risk, so the only signal is when someone like Alan Greenspan 'jawbones' the market, with comments about the settlement system or his famous "over-exuberance" speech. Otherwise, portfolio management exists on very short-term reactivity. The problem is the performance culture in financial management and, from a systems point of view, there is a clear and dangerous positive feedback loop created. They all buy the Dow as a big safe index and, surprise surprise, it goes up, so they buy it again.It is another tragedy of the commons -- everybody hedging their own risks, producing a ballooning of derivatives, but with few regulations on the overall system. The risks can be externalized onto the latest commons -- global financial cyberspace -- with very few rules, and it will ricochet around until banks start to fail, and still nobody is responsible for the whole system. But, since the Asian meltdown, there is now a lot of serious discussion, including articles suggesting that perhaps we do have to tax currency speculation. There are harmonisation pressures, but still based on the crisis model.

What are the biggest dangers in looking at the risk dynamics of financial markets, essentially a sub-system, while neglecting broader systemic effects or treating them as exogenous unpredictable 'shocks'?

Well, Asian-type meltdowns are the most obvious, which are partly a function of sloppy banking systems, cronyism, bubbles, etc. But when the 'Washington Consensus' folks at the World Bank and the IMF lecture the Asian leaders, I have to laugh. They have known this for decades and as long as everybody was making money they winked at it. Then, when it gets to be a real crisis, they rush in and say "Isn't this terrible?" I take it with a grain of salt -- public interest groups have been exposing the short-cuts to profitability taken by Asian economies for decades, the collusion, environmental and social costs and so on, it was quite clear this was coming.Any first year engineering or ecology student would know that if you take down the firewalls between economies and have this massive amount of money zipping around the globe, 90%+ of which is speculation, then of course volatility will increase, with bear raids and so on, which will ricochet around the system and keep going. We are now in a whole new domain, dealing with a global financial system where so many traders are thriving on volatility, but it damages the real economy more and more, hurting both corporations and people on 'Main Street'. The head of Brazil's central bank said in October that no country need fear as long as its fundamentals are right. A couple of days later, speculators were going after the Real, and it is real people who suffer -- they had to raise interest rates, and they now face the risk of recession.Currency raiders just go for one country after another and, when a central bank is foolish enough to say it will defend its currency and has a 'war chest', the traders are positively rubbing their hands. I have been urging for a long time that we put a lot of circuit-breakers into effect and, until we do, the Asian situation will continue to ricochet. Wall Street is still kidding itself it won't be affected but, for example, Yamaichi was up to its neck in US treasuries which will have to be liquidated. Sooner or later the markets will raid the dollar -- nobody is immune to this now.

A key element of financial risk management is diversification. What are the broad implications of the massive increase in international diversification?

Now this is an interesting question because, from my perspective, it isn't really a massive increase in diversification. It is an internationalizing of a very narrow culture of portfolio management, driven by the assumptions of the Washington Consensus. In systems terms, I wouldn't call that diversification, I would call that herd behavior. What I call diversification is something quite different -- the strategy I try to use is a 'contrarian' strategy. I want to be invested in companies that are not in any of these indexes, maybe haven't even gone public and might never have done an IPO, because they don't want to have to deal with day-to-day evaluation by portfolio managers who don't deal with long-term risks. The kind of companies that I am looking for are those that have better thermodynamic performance, in other words trying to reduce to a bare minimum the flow of energy and materials through their balance sheet. Even better are those I call in 'Building a Win-Win World' the "attention economy", where the content of GDP is dematerializing and going towards services. I don't mean the classic definition of financial services, since 90% of that is speculation, but I mean the kind of services where the concept is that, instead of everybody buying a car, a community can rent them. The idea is that people don't want to buy the material goods, they want to buy the service that the goods provide, so you can immensely reduce the material and energy flows through the economy. The investments I look for are those in the solar-age, information-rich economy -- that kind of international diversification is very rare. What we have is a financial mono-culture, driven by GNP-measured economic growth, but I am confident that the whole climate debate is going to shift attention towards what real diversification might look like -- diversification towards an inherently less risky economy.

How do the systematic risks differ from, say, 25 years ago? Do you agree with those, including Soros and Volcker, who say that the financial system is now fundamentally unstable?

Mostly, the environmental systemic risks have become more acute, because we have allowed them to drift up to the planetary level, where they have to be solved by global agreements. I came into this at the two-country level, looking at the US-Canadian use of the Great Lakes. Today, 160-odd countries had to sign the UN's Framework Convention on Climate Change. In terms of the fragility of the financial system, the fact that it is now global without any good regime of rules makes it just as difficult, because everyone has stakes in the existing system and nobody has responsibility for the whole, making it fundamentally unstable and very hard to fix. So, I would agree very much with Soros and Volcker.

If individuals are responsible for managing their own risk, who is responsible for managing systemic risk? Can it be managed?

We all are responsible for managing systemic risk, and we have pushed it up first to the state level and now to the global level. Yes, it will be difficult to create these international agreements, but it can be done. It will require, in the first instance, what I call a 'Global SEC'; agreements are being put together voluntarily since the various scandals of the past few years. You have got a lot more regulatory harmonization and disclosure. It will probably continue to be crisis-driven, so who knows where the next crisis will show up. In 1996, Alan F. Kay (founder of AutEx, the first electronic market for securities) and I made a proposal for the central bankers and Bretton Woods institutions to have their own foreign exchange facility, run as a public utility. This would address the absurd situation where they sit at the same casino table as the profit-maximizing traders, but with totally different responsibilities and objectives. I fear that it will take a lot more runs and bear raids before anything like this happens though. It's very easy for governments to get together and make rules if they want to -- they can set up a very complex international agreement -- look at the WTO. A lot of politicians at the nation-state level are pleading that they have no power in the face of global markets. Well, I'm not buying it! But now, here's a private-sector approach to managing this kind of systemic global risk -- one that I am working with several colleagues to put together -- "The Virtuous Circle Global Sovereign Bond Fund." Basically, you take the world's best-managed countries from the points of view of indexes such as the Human Development Index, the Domini 400 and every other source we can find on good political risk management -- those countries that do best in terms of managing their resources, human rights, good standards of democracy, observance of UN conventions, labour standards, Agenda 21, countries that don't have big military budgets. Those will be the buy list. Then we give the mandate to a fixed income manager, to manage within this universe. We have not back-cast this yet, but it is perfectly clear to me that if you take a portfolio of countries that have a long-term view of value and risk, their bonds will do better -- the Costa Ricas, the Nordic countries, Canada and so on. So this fund is about a far more sophisticated form of political risk analysis. We have not floated this yet as we have still to find the right manager, but we think it should be very attractive to pension funds, who are also managing for the long term. Another area, which I wrote up in 'Building a Win-Win World,' is military and political violence risk. We at the Global Commission to Fund the UN, proposed that this should be managed by setting up a United Nations Security Insurance Agency (UNSIA), enabling countries to redeploy their military budgets to civilian purposes. Insurance companies would go in and do the risk assessments and write the policies. So, yes, global systemic risk can and should be managed. We have several Nobel prize-winners on board and a lot of support for this approach -- the principles are now being taught at the London School of Economics, for example. These social innovations need to be kept in the loop, publishing and making sure they are available so that, when politicians are in crisis, there are well thought-out solutions they can look to.

Since massive public bail-outs of financial institutions are increasingly impractical and, even in a conventional risk analysis, undesirable, would you support the management of systemic risk via some kind of global regulatory body?

Yes, of course. It does not have to be one enormous body though, but should be set up according to function. The Global SEC could handle disclosure and harmonization of securities rules etc., the public utility foreign exchange (above) for central banks, the bond fund idea in the private sector, the UNSIA insurance solution for the military and political violence domain, the International Bank for Environmental Settlements in the environmental domain -- I can see that there will have to be literally dozens of these new facilities to deal with global systemic risk.

If such bodies were to exist, should they be set up by the relevant industry or, for example, by the UN?

I think that they should all be public/private/civic partnerships. You need the relevant level of government for the public-sector piece (be it the UN, national governments or municipalities, say); you need the private sector so that you can privatize appropriately the piece of it that can be run as a market; you must also have the civic-society sectors, whoever they turn out to be -- they are the 'users,' the ones who actually relate to the population who need the services. The most interesting game going on at the moment is that of capturing standards. There are about 90% old industrial companies, who need to transform themselves, trying to lower standards, or at least keep them as they are. They are the herd. There are perhaps 10% who are contrarians -- companies already poised to serve the 21st century markets, being cleaner and greener etc. They are the ones trying to raise the standards in order to survive and win. At the June 1997 New York Earth Summit, politicians were wringing their hands about the estimated $600 billion or so needed to fund the shift to sustainability -- however, some $1 trillion dollars subsidies unsustainable industry, transportation and agriculture which is externalizing risk onto commons. Governments could actually remove this element of systemic risk, level the playing field, and have $400 billion left over.

What might be regulators' core objectives?

The core objectives of all of them must be to protect global commons, and to protect so far unprotected taxpayers' in every country. Look at what the IMF is doing -- we are up to about $100 billion and counting for the bailouts in S.E. Asia, which is taxpayers money for which we get nothing -- we are bailing out investors and speculators. New institutions must protect the world's taxpayers as well as its public resources.

What about the argument that what is needed is more liberalization so as to allow markets to function properly -- that it is intervention that exacerbates volatility?

I don't buy that argument at all! This is a paradigm problem -- this is the Washington Consensus. It is typical that, when an old paradigm is dying, the tendency, when faced with the difficulties it is creating, is to call for larger doses of the old medicine. This is what the IMF et al are telling the Asian economies -- open yourselves up even more to market forces, and somehow that will do the trick -- but it doesn't work that way. You have to take a wide shot and say "Hey -- have we got the wrong pair of spectacles on?" Yet, with so much money, power, influence and people's jobs resting on these old assumptions, it is very easy to crowd out the voices on the sidelines who are coming from a totally new perspective -- these guys all come from the same culture and all talk to each other. Tessa Tennant from NPI was saying recently in Hong Kong how interesting is was interfacing with new companies about obviously 'picking the ripe fruit' -- energy efficiency etc. These are the $20 bills lying around all over the floor but, if you're a conventional economist, you say "Oh, it can't be real because somebody else would already have picked it up." Folks like us go around picking them up, and they turn out to be real. This is the problem with the neo-classical view -- you are backing the car into the future looking through the rear-view mirror. I wonder, how may crises do we have to have before the learning experience takes root?

In the scientific community, the Precautionary Principle is gaining credence as an appropriate way of dealing with the risks of irreversible change. How might it be applied to the investment community?

It really has to be social and environmental screening of all investments. Furthermore, you need to look at what a company does with its risk dollar. I would not invest in any company that used its risk dollar defensively, i.e. buying insurance and public relations. I'd look at those using it to redesign the production process and product, tightening up the risk overhang of environmental policies which were inappropriate. That’s why I've been in the ground floor of the screening industry, which is almost a financial services sector of its own. The Domini 400 Social Index has outperformed the S&P 500 since 1990 and, the more realistic the screens get and the more they are applied, the more confidence you have in the investments you are making. That's why I think there is a place for this bond fund, extending this approach into sovereign risk management.

How can investment managers, constrained by existing legislation and market expectations, take account of a wider systemic view?

I think that investment managers who are really savvy are beginning to take the contrarian’s view and, once they start, they find that all sorts of incredible opportunities come their way. If you follow the herd and say you have to stick to the prudent-man principle, which is basically neo-classical, short-term profit maximizing, at some point they are not going to perform as well as companies which have taken a longer view (and we have numbers to show this now). So, I think it behooves investment managers to check out social screening, the activities around rule-making, mission-related investing -- all the new thinking that they can access very easily from places like the Social Investment Forum in the UK. When they begin to re-cast their thinking, all kinds of new investments will pop up as very appropriate. The other thing they can do is to educate their clients about these kinds of long-term risk rewards and teach them to be patient investors -- it is the short-termism that is really wrecking everything. This is why we need a Global SEC and, who knows, we may find all kinds of ways to slow down the volume of speculation, which is so destructive to real investments.