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Converging to a comprehensive risk-adjusted fiscal sustainability analysis


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Presentation from ADEMU Fiscal Risk and Public Sector Balance Sheets Conference at the University of Bonn, July 6-7

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Converging to a comprehensive risk-adjusted fiscal sustainability analysis

  1. 1. Discussion of Converging to a Comprehensive Risk-Adjusted Fiscal Sustainability Analysis by George Kopits Martin Larch EUROPEAN FISCAL BOARD (EFB) ADEMU Conference on Fiscal Risk University of Bonn July 6-7, 2017
  2. 2. 2 Some issues for discussion • Assessing risks versus hedging against risks • Exogenous shocks versus endogenous risks (taking into account important second, and higher, round effects) • More information – transparency - accountability • Volatility and growth 2 Outline
  3. 3. Assessing risk versus hedging against risk 3 “ … the right answer to crisis avoidance is controlling risk. The appropriate conceptual framework is Value-at-Risk – a model-driven estimate of the maximum risk for a particular balance sheet situation over a specified [time] horizon. There are genuine issues of modelling, but there is no issue whatsoever in recognizing that this approach is the right one. If authorities everywhere enforced a culture of risk- oriented evaluation of balance sheets, extreme situations such as those [during the financial crisis] in Asia in 1997 would disappear or, at the least, become a rare species. ” Rudiger Dornbusch (1998, 2002)
  4. 4. 4 "How do you hedge against the assassination of Archduke Ferdinand?" Douglas Rediker (FT 2017) former IMF executive director for the USA. "Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character." Frank Knight (1921) Risk versus uncertaintyAssessing risk versus hedging against risk
  5. 5. 5 • Forecasting is always a matter of grappling with uncertainty. • But then, do we have all the information we need in order to set accurate odds in the first place? • Extrapolation from past experience sound only if we can assume that observations are generated by a stationary process. • And even if we assessed risks correctly, can or do we want to do anything about it? Policy response? Assessing risk versus hedging against risk
  6. 6. Exogenous shocks versus endogenous risk 6 Focusing on exogenous shocks is not enough. Exogenous shocks trigger an amplifying spiral, via declines in asset prices and reductions in credit expansion which give rise to major second, and higher, round effects. New methods of risk assessment (e.g. systemic CCA) •put greater emphasis on interconnectedness; •capture linkages between institutions and the extent to which they precipitate or amplify general market distress; •can be used to simulate the mitigating or amplifying effects of alternative macro-prudential arrangements.
  7. 7. 7 Exogenous shocks versus endogenous risk • How are spill-overs from the financial sector to the public sector modelled? • Interconnectedness is already difficult to model for financial sector: what are implications for government sector? How to value implicit guarantees? More than implicit guarantees? • Are there differences in spill-over risks from and to government sector in euro area countries versus parts of complete monetary unions?
  8. 8. 8 More information-transparency-accountability More information only necessary condition for better policies Budgetary risks of ageing well known since at least mid-1980s; some EU member states still ill prepared. Accountability improves with more information only in case of fiscal illusion Better information does not solve political economy problem
  9. 9. 9 Countries that have experienced financial crises have, on average, grown faster than countries with stable financial conditions. Rancière, Tornell, Westermann (2008) Systemic Crises and Growth, Q J Econ, 123 (1): 359-406. […] the “bright” and “dark” sides of financial innovation. We find supportive evidence for both the innovation-growth and the innovation-fragility views. Beck, Chen, Lin, Song(2016) Financial innovation: The bright and the dark sides, J of Banking&Finance, 72:28-51.  Are crises the price to pay for higher growth? Volatility and Growth
  10. 10. Converging to a comprehensive risk assessment 10 Baseline Adverse scenario t
  11. 11. 11 Converging to a comprehensive risk assessment t Baseline Adverse scenario
  12. 12. 12 Converging to a comprehensive risk assessment t Baseline Adverse scenario
  13. 13. 13 Converging to a comprehensive risk assessment t Baseline
  14. 14. Thank you for your attention