RISK MANAGEMENT AND THE
RE-INVIGORATION OF REFORM
February 2003
Nicholas Gruen
Ric Simes
Lateral Economics
Chief Economist
ICAP (Aust)
Traditional ideas of the economy
Micro reform 1983 forward
Facilitating internal and external trade
Managing Risk: a new theme for reform
A new agenda for reform
•Theory is fairly mature and much of it is robust
•Results are
often commonsensical
sometimes surprising
 Governments should often invest more offshore
 Governments can lower risk by increasing their
exposure to risky assets
•Gains are substantial
The optimal allocation of risk
•Governments always have an intrinsic advantage in
the passive bearing of risk …
governments are collective institutions > pooling is inherent
taxation powers give them lower costs of capital and bearing risk
•… while individuals and markets will often have
large advantages in actively manage risk.
Suiting individual preferences
Generating and making use of local information and incentives
The optimal allocation of risk
Passively bear risk Actively manage risk
Larger role for
Govt
Non-diversifiable risks
(eg incomplete markets)
Severe externalities
(macro-economic
feedback)
Larger role for
the private
sector
Adverse selection and other
incentive problems
Low monitoring costs
Diverse preferences etc
Two functions for government
•Government should actively help manage certain
risks particularly
 systematic risks to the macro-economy
 where there are large externalities
•Where risk is best managed by the private sector,
government can contribute by facilitating the
development of the right instruments and
infrastructure
Five areas of public policy *
•We sample five areas of policy where a risk
perspective offers scope for gains …
1 public private partnerships
2 fiscal policy
3 the management of financial crises
4 retirement income policy and
5 the management of the government’s balance
sheet.
*Order differs in paper
1. Public private partnerships
The principle governing risk transfer is that risk will be
allocated to whoever is best able to manage it at least
cost, taking into account public interest considerations.
If risk is transferred inappropriately, the Government
will pay a premium.
Partnerships Victoria, 2001.
1. Optimal risk allocation
Passive
Bearer of
Risk $
Active Manager of Risk $
Qantas, CSL and various other privatisations
Passive
Bearer of
Risk $
Private
Govt
Active Manager of Risk $
Government tenanted properties
Passive
Bearer of
Risk $
Private
Govt
Active Manager of Risk $
Road development
Passive
Bearer of
Risk $
Private
Govt
Active Manager of Risk $
1. Public private partnerships
•There may be continuity of PPPs with earlier
government risk minimisation rather than
optimisation.
•Victorian Government draws attention to the benefits
of “risk transfer, relieving government of the
substantial, but often undervalued, cost of asset-based
risks”
•Governments ‘compete’ to take on risks through the
‘public service comparator’ which has an illustrative
real discount rate of 6% for government.
2. Fiscal policy
•Theoretical disputes aside, there is broad support in
Australia for countercyclical fiscal policy.
The principles of sound fiscal management
[include] that … fiscal policy contributes … to
moderating cyclical fluctuations in economic
activity, as appropriate, taking into account the
economic risks facing the nation …
The Charter of Budget Honesty
2. Fiscal policy
•A bi-partisan public commitment to ‘balance through
the cycle’.
•An inability to run large sustained surpluses through
the upturns.
•Thus either
our capacity to run deficits during downturns is
compromised or
‘balance through the cycle’ is code for small surpluses,
large deficits and deficits through the cycle unless downturns
become much rarer.
2. Fiscal policy: Some responses
•Some countries are tackling this ‘fiscal drift’
successfully.
•New Zealand is now partially funding its
governments retirement incomes liabilities from the
budget.
•In effect this ‘moves the goalposts’ of a balanced
budget by re-definition of the goal
2. Fiscal policy: Norway’s Petroleum Fund
•Established in 1990 to invest the proceeds of the
North Sea Petroleum windfall
Percentage of GDP
Petroleum and financial wealth
250
200
150
Petroleum
w ealth
Sum
100
50
Financial w ealth
0
1970 1980 1990 2000 2010 2020 2030 2040 2050
Illustration from Government Long Term Programme 1997
2. Fiscal policy: Norway’s Petroleum Fund
•Norway has run large budget surpluses ever since!
Net Foreign liabilities
Norw ay
Finland
Korea
Sw eden
Australia
Denmark
New Zealand
Iceland
United Kingdom
Spain
Netherlands
United States
France
Austria
Germany
Canada
Euro area
Japan
Belgium
Italy
-150%
-100%
-50%
0%
50%
100%
150%
2. Fiscal policy: some numbers
•Prudent policy requires governments to be able to
apply sufficient stimulus during downturns.
•Average downturn lasting for two years with the
stimulus removed over the following two years
suggests access to at least $30 billion.
•Options include, access of an existing bond market,
the accumulation of financial assets, the issuance of
new paper and the printing of money.
•We need net government assets of around 30 billion
before we should contemplate removing bond market
2. Fiscal policy and government balance sheets
•Fiscal policy also needs to be able to address
medium-term issues …
•… including through sustaining sizeable (structural)
surpluses).
•New institutional arrangements and changed
atmospherics are central.
•As discussed, Norway and NZ (and others) have
moved down this path, so can we.
3. The management of financial crises
•Low risk events with large and lasting consequences.
•The literature on the minimisation and management
of financial crises is still in its infancy …
•… but the Australian economy and financial system
scores very highly on any reading.
3. The management of financial crises
•“Despite its close trade and financial ties to Asia, the
Australian economy exhibited few signs of contagion
from contiguous economies, arguably because
Australia already had well-developed capital markets
as well as a sturdy banking system. But going
further, it is plausible that the dividends of financial
diversity extend to more normal times as well. The
existence of alternatives may well insulate all aspects
of a financial system from breakdown.”
Alan Greenspan
3. The management of financial crises
•Any alternative to bond futures would involve
instruments based on liabilities of the major banks
(eg swaps, or US treasuries hedged into A$).
•A consequence of the loss of diversification (and a
greater degree of implicit government guarantee)
would be the need for tighter regulatory oversight.
4. Retirement incomes: Risk sharing
•IG risk sharing tends to be best with defined benefits
where the benefits are state contingent (eg pensions).
•Government is best placed to manage risk across
generations because of its taxing powers.
•Also, to the extent that it influences aggregate saving
rates, government can affect the total resources
available to any particular cohort.
4. Retirement incomes: practice
•The shift to individual accounts was driven by a
range of important considerations …
•… to allow for individual preferences …
•… concerns over the management of funds and …
•… especially, the need to lift national saving levels
without being able to do so on the Government’s own
account.
•Risk considerations entered in a secondary way.
4. Retirement incomes: some consequences
•A leading funds manager advertises the fact that
selecting a manager who outperforms by 2% pa
matters.
•Two individuals with identical histories and
preferences that face the possibility of receiving
retirement incomes, say, 20% apart may have been
happier to have shared the risk beforehand.
•Similarly, Burtless (2000) found that pensions
received by workers in the US averaged 80% of
replacement rates in 1972 and only 40% in 1974.
4. Retirement incomes: role of government
•Many of the individuals bearing the increased risk are
not well placed to bear or manage it …
•Reflecting this, many do not want to manage it . . .
•… heightening the need for government to ensure
that the infrastructure and tools for individual risk
management are effective.
•Government can also influence national saving if
there is over or, more frequently, under accumulation
of assets for generations as a whole.
5. Government balance sheets
•Such objectives will arise more naturally if we can
start to view Government’s balance sheets as an
integrated whole.
•There will be governance issues, but manageable ones.
These will be addressed in this afternoon’s session.
•Here, we simply note that the approach being
advocated allows important questions such as IG
income smoothing to be addressed.
Conclusions
•A focus on risk management suggests a range of
improvements to economic policy.
•Partial views of debt, deficits and public ownership
have side-tracked the desirability of integrating
effective risk management into many areas of public
policy.
•As part of this, the Government’s own portfolio of
assets and liabilities should be managed as a portfolio


both as a whole of government portfolio and also
in context of the wider national economy.
Implications for the debate over the bond market
• Counter-cyclical fiscal policy is aided by ready access to the
bond market or, failing that, a portfolio of financial assets.
• Retirement income policies (as well as insurance more broadly
or hedging by the corporate sector) argue for the government
to ensure the best infrastructure and instruments for the private
sector management of risks.
• A broad diversified financial system underpinned by strong
banks and government paper represents best practice in
minimising and mitigating the dangers of financial crisis.
• (Risk management is but one line of argument in support of
the bond market – others include cost of capital, the efficient
allocation of saving into investment, etc.)