Subscribe to this blog's feedFor anyone forced to make a speech about the risk management industry, this quote might come in handy:
It is often supposed that the costs of production are threefold, corresponding to the rewards of labour, enterprise and accumulation.[In other words: salaries, shareholders' dividends, and debt costs - OTC.] But there is a fourth cost, namely risk; and the reward of risk-bearing is one of the heaviest, and perhaps the most avoidable, burden on production. This element of risk is greatly aggravated by the instability of the standard of value. Currency reforms, which led to the adoption by this country and the world at large of sound monetary principles, would diminish the wastes of Risk, which consume at present too much of our estate.
From the preface to Keynes' Tract on Monetary Reform (1924).
Keynes was talking about inflation risk. Given the time he wrote it, that's understandable; as Brad DeLong explains, his concern was to argue against a return to the gold standard, abandoned during the fiscal stresses of the First World War (and reintroduced, tragically, the next year by then-chancellor Winston Churchill), and in favour of a strong inflation-targetting central bank. But, of course, the point holds for any sort of risk; the reason we are willing to pay so much to get rid of risk is that the shadow of an uncertain future has a terribly chilling effect on any sort of enterprise.
Comments (1)
A great quote from a great theoretician. A couple of thoughts though:
- In a narrow business economics sense, what is a cost for one must also appear as a revenue item for someone else (at least as viewed in isolation). In other words, if risk has a cost, who is on the receiving end of that cost stream? It must be one of the aforementioned three sources of costs; namely the workers, the shareholders or the debt holders. As such, the cost of risk isn't really a fourth source of cost, it is embedded within the three core sources of cost. Indeed, what are the costs of labour, equity and debt driven by? Alongside the economy's overall ability to grow in real terms, it is primarily risk. The latter part, cost of debt, also has three very important risk premia: Inflation risk premium in government rates (to which Keynes was pointing), liquidity risk premium for physical securities and credit risk premium.
- I would argue that the statement "But, of course, the point holds for any sort of risk; ..." is somewhat inaccurate. In principle it is only non-diversifiable risks that command a risk premium. Degree of diversifiability of any particular kind of risk is of course a subject of debate as well as conditional on the context and perspective of the discussion. Often diversification is constrained in a number of ways, e.g. by investment mandates, barriers of trade, frictional costs and underinvestment costs associated with collecting new money to a struggling company, but still, in the big scheme of things, only non-diversifiable risks carry a risk premium. What are the major ones? Interest rate risk (to which Keynes was referring), Systematic equity risk (the equity cost of capital), systematic credit risk, and maybe a few others (such as commodity costs that the global community is short, e.g. energy price risk)
Posted by Halvor Hoddevik | March 14, 2007 8:42 PM
Posted on March 14, 2007 20:42