BOOK REVIEW: Ian Bremmer & Preston Keat's The Fat Tail
In their entertaining new book, The Fat Tail, Eurasia Group investment strategists Ian Bremmer and Preston Keat observe that while banks likely spent $8 billion on credit-risk software in 2008, most spent “far less energy on the assessment and management of political risk.” It’s easy to make the argument that banks and businesses of all stripes ignore risk of the policy variety at their peril.
To show why, all one would need do is return to October of 1929. It was then that the notorious Smoot-Hawley tariff bill was being debated in Congress, and while President Herbert Hoover didn’t sign the bill until 1930, it became apparent in October of ’29 that he would. Stock markets serve us best for pricing in the future, and with Hoover set to put his stamp on a bill that would retard the growth enhancing expansion of the world’s division of labor, investors didn’t wait until 1930 to take stocks down 12.5 percent.
Those attuned to political risk back in 1929 doubtless saved themselves a great deal of anguish, and in writing The Fat Tail, Bremmer and Keat seek to explain the importance of calculating political risk as a significant part of all investment calculations. Given the growing role of Washington, London, Beijing and other political capitals in the world economy, their book is well timed.
First up, it must be asked what the authors mean by a “Fat Tails”. They describe the latter as “unexpectedly thick ‘tails’” at the “ends of distribution curves”, and they “represent the risk that a particular event will occur that appears so catastrophically damaging, unlikely to happen, and difficult to predict, that many of us choose to simply ignore it.” That is, of course, “until it happens.”
As they make plain, a better understanding of the politics of Russia in the late ‘90s would have made a big difference for investors trying to divine whether or not the regime in place would default on its debt. Russia certainly had the revenue potential to honor its commitments, but a failure to understand the country’s politics left a lot of investors burned.
In this case, it’s important to understand that political success is not always achieved through economic success. Take for instance Mexico in the late 1930s. With policymakers in the United States and England occupied with economic troubles and a looming war, Mexican president Lazaro Cardenas felt the timing was right to make a political statement whereby he nationalized the country’s oil industry.
As the authors note, the nationalization “was a resounding political success”, but as they also point out, from an economic perspective Mexico lost big thanks to the departure of human and financial capital that had previously made this industry so vibrant. In this case, economic analysis would have pointed to the folly of nationalization, while astute political analysts might have reached different conclusions that would have saved investors a great deal of heartache. Political risk must always be accounted for, and differentiated from rational economics.
Reversing the scenario described above, Bremmer and Keat note that investors not only misread Luis Inacio Lula da Silva’s (Lula) electoral chances in 2002, but having heard his often fiery rhetoric, they feared that his victory would among other things lead to a default on Brazil’s debt. Once again, the political economics of his victory were misunderstood in that having suffered previous defeats, once in office Lula moderated his message. As the authors remember for us, “few experts” were able to forecast the political incentives Lula “would inherit to stick to restrictive fiscal and monetary policy.” In short, a correct political read of Lula could have translated into investment gains for those who availed themselves of analysis that went beyond the economic.
And while it’s often said that governments are merely the puppets of corporate interests, the authors helpfully show how that’s not the case. This speaks yet again to the importance that investors must attach to the political outlook in making investment decisions. Specifically, in the lead up to World War I, the authors note that “most British and German bankers bitterly opposed it” with their investments in mind. Sadly in this case, they remind us that “corporations cannot do much to prevent geopolitical shifts from happening.”
Happily, The Fat Tail is more than a book that makes the clear case for applying policy analysis to investment strategy. Indeed, one of its most appealing attributes is the history that it offers. From the psychological impact of ineffective guns when it came to the Spanish invasion of Mexico to the Soviet’s role in the creation of the Eurodollar market to Wal-Mart’s brilliant response to Hurricane Katrina, the authors do a great job of keeping the reader interested in what on its face might seem a bland subject.
The above in mind, the differing fortunes of German aircraft makers Fokker and Pfalz in World War I’s aftermath caught this reader’s eye the most. Fokker thrived after the war thanks to its greatest asset being its intellectual know-how when it came to airplane manufacture. This was easily transportable to the Netherlands. Conversely, Pfalz was less reliant on intellectual property, and instead had thrived due to wartime opportunity. There’s a lesson here for the many businesses lined up in Washington for surely ephemeral government “stimulus.” As for our federal government that presumes it can tax productive businesses and individuals without consequence, it should be known that as we’re increasingly an economy of the mind, excessive taxation may drive our human capital out of the country altogether.
On the regulatory front, the authors make the essential point that regulators, like armies, are always fighting the last war. Sarbanes-Oxley was passed to fix the Enron and Worldcom mistakes with greater balance-sheet clarity, but as the last year has shown, it was very unequal to the task. Ultimately regulators never know what to regulate until after the fact, and even with hindsight they do a poor job. This writer’s not holding his breath, but maybe, just maybe, the political class might in time wake up to the simple reality that as they lack a hotline to the future, regulators are at best an inhibitor of productive economic activity.
There were a few disagreements with Bremmer and Keat. They suggest that the Yom Kippur War triggered an oil “price shock”, but since the U.S. was the recipient of more oil after the war than before, they perhaps could have better described the oil “shock” as a weak dollar shock. Further on they note that for “a local producer, a currency devaluation makes products cheaper to sell abroad.” Were that the case, Argentina, Turkey and Zimbabwe would be economic powerhouses. More realistically, inflation steals the alleged benefits of devaluation, and as we’re nothing if not a world economy, a cheaper currency would drive up the costs of the various imported inputs that make up a finished product. Devaluation’s virtues are frequently extolled, and its demerits not enough.
One other disappointment likely resulted from an editing error: in the second chapter the authors ask if the U.S. has “finally entered a period of relative decline?”, and allude to a full discussion of the question later in the chapter. Their views on this subject would have been very interesting, but they were hard to find.
Despite these small quibbles, The Fat Tail is a very worthwhile and fun read. What’s unknown, however, is how easy it might be to apply very essential policy analysis to the frequently numerical art that is investing. Indeed, as the authors make clear, it’s hard enough to predict future events like the Bolshevik Revolution, and even in hindsight there’s broad disagreement as to its causes. That being the case, we know that political risk is an essential investment input, but can we profitably analyze it?