Fiscal lessons: 3 (theory of interest rate - induction)

Basically ‘debt’ means the state of owing something. Whenever the term debt is coined the first thing that comes to our mind is ‘interest rate’. The concept of interest rate goes back to thousands of years. Apparently, it’s an old idea.

Starting with the basics, interest rate simply means a few percent a year. Now the question is why it is a few percent a year? And why not something completely different? And why it is even a positive number? Or what explains that? To understand these basic questions, let’s go back to history of thought.

Eugen Von Bohm-Bewark, an Austrian economist from the 19^th century, wrote a book on theory of interest. He had given the three basic reasons of what causes interest rate. One of them was technical progress. As the economy as a whole starts knowing the easier ways in which the work can be done, the productivity level increases. So as per this concept, we can say that the interest rate is nothing but a rate at which technology is progressing. So if we say that interest rate is 5%, it means that the technical progress is speeding at 5% level.

Another was advantages of roundaboutness. It says that there’s a direct relationship between roundabout production and productivity level. There’s a simple explanation to this. That if someone asks us to do some work right now then we’d be doing it in the most direct way possible. But if we have got some more time to do it then perhaps we’d be doing it in a more roundabout manner. Like if we have got some extra time, we may analyze the whole situation first or we may look for another method or technique or something which can enhance the quality of work. In short, more the time we get to complete a work, better are the chances to get it done effectively. So may be interest rate is the measure of advantages to roundaboutness.

The third reason that he gave was time preference. The term itself suggests that rational people prefers present over future. Basically this falls into behavioral economics. It’s a psychology of humans that if we are given, let’s say, some chocolates or some confects for that matter, we’d prefer to eat them now instead of eating them in a near future with more joy. This is thoroughly explained in the Marshmallow experiments conducted by Zimbardo. It says that even if we know that we’d be enjoying more advantages by consuming the thing in future than in present, we have a tendency to be impulsive and we’d rather prefer to consume it straight away. So may be interest rate is the rate of time preference. So if we say that interest rate is 7%, it means that people are 7% happier to get something now to get in the future.

Fiscal lessons: 2 (Risk management in insurance & the AIG saga)

BACKGROUND:

The insurance sector has been immersed in a permanent updating process, fostering the changes needed to adapt both to the new economic environments and to the growing levels of safety, transparency and effectiveness which are increasingly being demanded by financial markets and citizens. Their growingly frequent uncertainty necessarily leads supervisors and companies to look for higher levels of safety through new approaches to solvency, supervision and risk management procedures.

Basically ‘insurance’ is all about ‘risk pooling’. Where many people invest their money to get protection against the future loss. Insurance companies are in the business of taking risks. Worldwide these companies write policies that deal with specific risks, and in many cases, even underwrite exotic risks. As a direct corollary, therefore, insurance companies should be good at managing their own risks. However the truth is a little far from that! Most insurance companies are very good at assessing insurance risks but are not very good at setting up structures in their own home to manage their own operating and business risks. And failure to manage such risks can be proved fatal to their business.

AIG SAGA:

AIG stands for American International Group. It was founded in 1919 in Shanghai. Today, AIG is the biggest insurance company in the world. But something went wrong during the USA subprime crisis (2007-08) that eventually led to the situation where Federal government had to come to the rescue in bailing out this insurance giant. The primary reason for this debacle was the failure of independence assumption under their risk modeling. The company was exposed to real estate risk. The reason why their risk model failed was they assumed that house prices can never go down. But ironically what actually happened was house prices fell everywhere in the country. They were taking risk,

1. by insuring against defaults on companies whose credit depended on the real estate market.

2. by directly investing in the housing sector.

So because of the collapse of housing sector in USA, AIG was about to fail. At that time the federal government had to bail out the company by pouring in $182 billion through TARP (Troubled Assets Relief Program). This was a massive amount so some people protested it but this was necessary step that the fed had to take as AIG, being such a large corporation, was linked to lot of other financial institutions, banks and other insurance companies as well. Now they all were subject to failure as their investments stuck too! So it was feared that this may lead to the destruction of the whole financial system. And that is why Fed took this outrageous decision.

So this is how AIG failed in managing the risk and almost went bankrupt. This case was also a deterrent example to the other corporations.

NEW PARADIGM:

“Change is the end result of all true learning”-- Aristotle

Recovering from such a big disaster could not be easy. But AIG did that. in fact it did that so well that today, AIG is a hot stock again in the market. After this incident, now--Insurance companies are no longer looking for single investment option. Also they had diversified their portfolio into different investment alternatives available. besides, Firms are looking to not only reduce the operational risk of the firm, but to make sure that they are only accepting non‐operational risks in the context of their total portfolios.