Friday, January 15, 2010

The Economy Wins... Or Losses

A new report from the World Economic Forum says that economic risks, not geopolitical incidents, terrorism, or natural disasters, are the most likely and most damaging global risks in the coming year. The figure below is the headline image from the report. All the labels have been added for ease.

The chart color codes economic (blue), geopolitical (gray), environmental (brown), societal (purple), and technological risks (orange). {Author’s evaluations in presence of colorblindness}. The horizontal axis provides a measure of how likely an event is and the vertical axis provides the cost if it does occur. As we move to the northeast region of the chart, the expected cost, the probability of an event multiplied by its cost if it occurs, increases. So the incident with the highest expected cost is an asset price collapse (6).

To some extent, all the blue in the upper right makes sense. Coming out of a financial crisis economic risks are still high and potentially costly. Of course, one of the events in the figure has already gone from possibility to reality. The figure rates an earthquake at only a 1-5 percent chance. The quake in Haiti has removed all chance form the calculation.

So could it be that a group of economists, funded by the financial market-dependent Swiss government, is simply overstating economic risks. Haiti’s earthquake is not itself a good indicator. Massive quakes are rare. The more surprising divide is the separation of geopolitical risks. The most likely geopolitical risk is the vague global governance gaps. The most probable discrete event, Afghanistan instability rates below the probability of economic collapses and weighs in at only a quarter to a third of the cost. It may be that economists simply don’t evaluate the risks of coups or insurrections as well.

There is another gap that the WEF should worry about, the one between economists and financers on one hand and foreign policy experts and military strategists on the other.