No Comment, Six Questions — March 25, 2009, 10:12 am

Six Questions for Ian Bremmer, Author of Fat Tail

Just in time for the global financial crisis, EurasiaGroup president Ian Bremmer has a new book. Co-authored with Preston Keat, it is called Fat Tail, and it deals with one of the most complicated aspects of risk analysis: the occurrence of once-in-a-century but highly transformative events which are routinely disregarded by analysts–to their peril. I put six questions to Ian Bremmer.

1. Nassim Taleb’s book, The Black Swan: The Impact of the Highly Improbable, has a lot in common with your latest book–you’re both focused on improbable events that the marketplace under-assesses but which wind up having a powerful and unanticipated influence for investors. Where do you differ?

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Both books are essentially about “storm of the century”-events that appear highly unlikely to occur but that are earth-moving when they do. This is what I refer to as a “fat tail.” Both books argue that these kinds of events occur more often than we think. We also agree that risk managers too often fail to include these kinds of events in their risk models. In some cases, the risk is considered too unlikely to occur to devote substantial time and money to studying it. In others, there’s simply a fatalistic attitude toward catastrophe. “How exactly do I prepare my house for direct impact from a category five hurricane?” These issues create some of the problems that we’ve seen grow out of the subprime mortgage mess and the global financial crisis.

But the two books disagree on a crucial issue: Preston Keat and I believe that a good number of these risks can be measured and managed. An increasing number of the fat tails now roiling markets around the world are driven by political factors, elements with some degree of predictability-and the vulnerability of your business or your investments can be quantified.

2. Apply this to the energy market. The last year has seen wild fluctuation in oil prices owing to highly contradictory pressures–on one hand a sense of growing finality with respect to the projection of reserves and a realization that a large part of the still untapped reserves are in “difficult” emerging markets; on the other, a global financial crisis that looks suspiciously like a depression, driving down demand and the quantity of cash available for expenditure on energy. What does the “fat tail” thinking add to this calculus?

It adds that geopolitical risks related to energy are higher than people think. Everyone is so preoccupied with the financial crisis, for obvious reasons, that other forms of risk simply haven’t been “priced in.” Last July, when oil sold for $147 per barrel, concerns that the international conflict over Iran’s nuclear program might trigger an event that undermined oil supplies created a significant oil price premium. Today, the world is watching political officials rewrite financial rules and tracking the daily fluctuations of markets to gauge their reactions. Fewer market players are keeping an eye on Iran, but the Iran risk hasn’t gone away. If anything, the risk of confrontation will be greater over the next 12 to 18 months as Iran moves closer to a technological point-of-no-return and increasingly anxious Israeli leaders weigh their options.

The problem with fat tails is that they come from unexpected directions. When the world is generally focused on one big problem–like the first truly global recession–a larger number of risks fly under the radar.

3. On Friday we saw reports that Iran had launched a predator drone of its own. Of course, the conventional wisdom is that a technology edge keeps America and her allies out front; that the rogue states like Iran languish far behind. But you seem to think very little of the conventional wisdom.

The technology edge is narrowing. It’s increasingly easy for the governments of small states or terrorist and militant groups or even determined individuals to gain access to technology once reserved for the world’s most powerful states. We’re talking about everything from the proliferation of nuclear weapons down to the ability of pirates operating off the coast of Somalia to use GPS to attack ships hundreds of miles offshore. In the case of Iran, everyone is aware of those spinning centrifuges. Iran says that uranium enrichment is meant for a civilian nuclear program that can generate electricity; many outsiders believe is intended as fuel for a nuclear weapon. This conflict is a significant longer-term risk for a hundred reasons that are already well-documented. But the more immediate fat tail created by Iran’s access to increasingly sophisticated technology involves ballistic missile technology, Hezbollah, and Tel Aviv.

One day soon, Iran will ensure that Hezbollah has missiles with the range and accuracy to effectively target Tel Aviv from anywhere inside Lebanon. That’s a game-changer for Israel’s security, its economy, and its politics. More than half of Israel’s population and the heart of its economy are centered in and around Tel Aviv. As the city becomes more vulnerable to the threat of precision-guided missile attacks, those Israelis who are most directly involved in the economic life of the Jewish state will be the most vulnerable to attack–and the first to leave the country.

On the other hand, U.S. policymakers may find that America’s hard-power advantages (particularly its military capacity) will provide the United States with a more reliable and lasting competitive edge than its soft-power advantages (the international appeal of American culture and values). For example, despite an international drive to develop alternatives to hydrocarbon-based energy, governments around the world will depend on oil and gas to fuel economic growth for many years to come. Yet the world’s oil and gas supplies will come increasingly from potentially unstable parts of the world–the Middle East, the Caspian Sea basin, and West Africa. With the world’s only global naval presence, America is uniquely placed to ensure the free flow of all this energy. Why should China spend its cash safeguarding shipping through the Strait of Hormuz when America will do it for them?

America’s continued provision of global public goods will continue to include military challenges. As Iran and other emerging states develop nuclear technology, they leave their regional rivals with a choice: They can spend billions on a nuclear arms race or they can rely more heavily on Washington to anchor regional stability. The former is a lot more expensive than the latter. Some Eastern European states, increasingly anxious over Moscow’s newly belligerent foreign policy, will rely on ties with Washington for additional security. China’s growth will force Japan, and perhaps other Asian states, to rely more heavily on security partnership with the United States.

4. The collapse of communism led to a period in which the United States was the global leader–the “hyper” power, as the French say. But this position of global dominance is clearly fading, and a new system seems to be emerging. Give us a broad profile of the global political system you see rising in its place.

U.S. dominance is on the wane, but a true multipolar order is not on the horizon. A multipolar system implies that the governments of several countries hold competing views of how the world should be run and are willing and able to project political, economic, and military power in several regions at once. Instead, we’re seeing the emergence of a non-polar order, one in which America’s would-be global rivals are too busy with problems at home and in their immediate neighborhoods to take on the international responsibilities that Washington can no longer afford on its own.

Over the past 20 years, analysts have cast several countries in the role of America’s potential challenger. The European Union was already struggling with growing pains following the latest round of expansion before the financial crisis gave EU leaders another reason to focus inward. Russia’s leaders may be unhappy with the geopolitical status quo, particularly when it comes to the balance of power within several former Soviet republics. But they’re too busy at the moment protecting Russian markets, banks, and companies from the worst effects of the financial crisis and consolidating state control over domestic economic sectors to try to build some sort of Soviet-scale international challenge to U.S. power.

China’s international influence is far more commercial than military. Its leaders now face both a domestic economic slowdown that could push millions more workers into the streets and serious long-term environmental and public health problems. There’s little appetite within the leadership for foreign-policy-related risks, particularly when the geopolitical status quo has proven so profitable in recent years. India must contend with both China’s lengthening shadow and security challenges flowing across the border from Pakistan. Brazil appears to have no grander near-term aspirations than to promote stability in Latin America, manage the effects of the global financial crisis, and to play a broader leadership role among developing states. And, of course, the Obama administration is too consumed with toxic assets, bailouts, and financial regulations to take on new international challenges.

So who will take the lead on building a new global financial architecture that better reflects 21st century realities? Who will take the lead on multilateral efforts to address climate change? Who will create a new (and more credible) nonproliferation regime? Who will provide some momentum behind Middle East Peace talks? Who will provide the leadership to ensure that G-20 summits don’t simply turn into G-8-style photo opportunities with a wider angle lens? The lack of leadership will allow problems to more easily become crises-and to produce new fat tail risks.

5. Let’s assume that the pessimists are right and that the global financial crisis winds up looking like a somewhat softer echo of the Great Depression of 1929–35, and let’s assume further that G-20 and G-8 finance level meetings fail to find a common approach to response. What consequences would this suggest in fat-tail-think?

We can expect more shocks to the system. There are two developing trends I would underline. First, state capitalism is playing an increasingly large role in the global economy. Whether we’re talking about national energy companies, other state-owned enterprises, or sovereign wealth funds, it’s increasingly obvious that political officials now wield unprecedented influence in the performance of international markets. In the days of the Communist bloc, the state played the dominant role in a number of domestic economies. But these states were not nearly as well integrated into the global economy as the leading practitioners of state capitalism are today. Second, as I mentioned earlier, there’s a shift underway from the U.S.-dominated unipolar order of the past two decades toward a non-polar model.

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These two trends–state capitalism and the non-polar international order–have something very basic in common: In historic terms, neither will last very long. Years? Yes. Decades? That’s highly unlikely, because both trends are unstable. Ultimately, governments around the world will accept that state capitalism is not the most efficient and profitable way of allocating resources, and the absence of international leadership implied by non-polarity creates far too many fat risks. If no one accepts responsibility for coordinating multinational responses to transnational problems like financial crises, climate change, or nuclear proliferation, nearly everyone loses. Nature abhors a vacuum, and political leaders can’t afford open-ended domestic instability.

The bottom-line: If things unfold as your question implies, we’ll have a series of storms of the century… until a critical mass of political policymakers around the world agrees that something bold must be done to restore stability to the international system. Necessity will again prove the mother of invention as new international architecture is created that better reflects the true balance of 21st century global political and economic power. How long will that take? That will depend in part on how political and business leaders respond to fat tail risks.

6. The last depression was associated with tremendous political instability, labor unrest, and the rise of political extremism. What about this go-round?

For those analysts searching the world for signs of financial-crisis-inspired, large-scale social turmoil, history shows that civil unrest follows economic meltdown by about 12 to 18 months. That’s the time it probably takes for a critical mass of people to decide that lost jobs, high prices, and other economic problems leave them with increasingly little to lose by directly challenging their governments. Relatively cash-poor governments of developing states are clearly at much greater risk than those that can extend enough debt to muddle through.

Generally speaking, the occurrence of one fat tail can produce several others. With a global recession raising risks of different sorts of upheaval in a diverse range of countries, it’s important for those with risk exposure to think through a wide range of potential scenarios. In other words, the financial crisis has introduced an element of uncertainty that forces us to think less about “What is likely to happen next?” than about “What are the four or five likeliest scenarios and how should I be prepared to respond to each one?” We have to think in terms of worst-case scenarios too–not because they’re likely to happen but because they’re more likely to happen than they were last week and because their impact would be substantial.

There are a number of countries that are relatively vulnerable to low-likelihood, high-impact risks related to the financial crisis. A sharp swing toward nationalist authoritarianism in Russia, a financial and political meltdown in Ukraine, a market crisis in Nigeria that sparks civil conflict between northern Muslims and southern Christians, direct confrontation between the ruling Justice and Development Party and the military in Turkey, and a collapse of confidence in Argentina are each relatively unlikely. But fat tails breed more fat tails–and anyone who isn’t thinking through worst-case scenarios at the moment is accepting much more risk than is necessary.

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