Sunday, January 20, 2008

How increasing risk aversion leads to recession

Risk aversion is not a stable phenomena. It can increase and decrease depending on individual's and / or organisation's perception of their environment. Take for example a well known trend of many individuals to engage in more risky investments and gambling depending on their perceived level of wealth. So the better off they feel the less risk averse they become increasing the chance that they will engage in more risky investments, and speculative spending. On the other hand the less well off an individual feels coupled with perceptions of reduced opportunities for income generation the greater the increase in risk averse activities and behaviour.
The same is true for institutions and companies. When they anticipate difficult conditions they frequently become more risk averse, tightening boundaries and procedures, reducing innovative practices, and cutting costs, training etc and reducing productivity. Every organisation that starts to engage in risk averse behaviour accelerates the possibility of more organisations perceiving a threat and engaging in risk averse behaviour and so on.
Take for example the current credit crunch. A perception of increased risk in the market triggers the banks to reduce lending and start to call in existing loans, thereby weakening the quality of their existing assets. If this thinking catches on, which it usually does, as every bank watches each other, triggering a follow-my-leader spiral increase in risk aversion accelerating a slide into a recession.
So why do banks, organisations and individuals all contribute to the situation they fear the most?

The first thing to note is that the the situation has moved from one of a perception of stability, confidence in knowledge, apparent low risk and growth (a positive condition) to one of uncertainty, a lack of belief and confidence in the level knowledge held which heightens the perception (belief) of the possibility of decline (a negative emotional and cognitive condition), therefore a belief that the situation is high risk and disinvestment follows.
The uncertainty here that triggers a panic (recession) is that people find themselves in a situation where they have no way of analysing the situation, either because it is wholly new or the complexity of it prevents normal rational analysis, or the form of analysis is currently too immature ie no prior experience in this situation. In other words the belief in the knowledge they hold moves from one of more certainty to one of less certainty. The situation is compounded because people see that others are also uncertain and their beliefs are confirmed.
This uncertainty means that people are less likely to ignore worrying data than before. Any sign of problems in such situations are more likely to trigger disinvestment and risk averse behaviours than in situations where there is a confidence in the knowledge held.
The scene is set as people are watching for any signs of disinvestment, whilst preparing for action just in case. One event can then set off a chain reaction. Slow at first the reaction then increases in speed and ferocity as each event increases the uncertainty and risk aversion increases as panic ensues.
As each agent is acting individually rather than communicating and working on the situation collaboratively their emotional and rational involvement is one of self preservation rather than that of systems thinking. So increasing risk aversion helps to contribute to recession, particularly in, but not confined to the financial sector.
Makes you feel a whole lot better!

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