Shock proof?

©Reuters/Mainichi Shimbun

Managing risk could absorb more policy time around the world in the 21st century. How can policymakers be prepared?

In July 2010, Russia was in the throes of its most severe heat wave in 130 years. The resulting drought unleashed hundreds of tenacious wildfires that raged across 120,000 square kilometres of forest and farmland, killing 34 people. The flames consumed enormous swathes of wheat fields, and grain prices climbed by almost 20%. To head off a shortage, the Russian government banned grain exports, and other countries, fearing a repeat of the 2008 food crisis, began hoarding wheat. Speculating that prices would climb even higher, less scrupulous farmers in Russia went so far as to revoke pre-paid contracts.

Agriculture was not the only casualty of Russia’s wildfires. Several Russian automakers, including the state-owned AvtoVAZ OAO, stopped production and sent employees on enforced summer holidays. The crisis might have ended there, except that the high price of wheat, buoyed by floods in Australia and fierce winters in the US, are now thought by some to have fanned the revolutions in Egypt and Tunisia. In the jasmine, there was a scent of the burning taiga.

In short, Russia’s wildfires were a “global shock”. Barrie Stevens, co-author of a recent OECD report on global shocks, defines them as “major rapid-onset events with severely disruptive consequences that cover at least two continents”. In little over a decade, events like the terrorist attacks on the World Trade Centre, the H1N1 pandemic, tsunamis and earthquakes in Indonesia, New Zealand and Japan–not to mention the revolutions in the Middle East and North Africa–have reverberated around the world with a speed and power surpassing all attempts to contain them. Mr Stevens says we should be prepared for more shocks in the future.

Global shocks by definition do not give society time to adjust. The unprecedented degree of interdependence in today’s world makes it harder both to foresee their consequences and identify their sources. Factors along the way may amplify their impact. In North Africa, the frustration of young people faced with high unemployment and political repression was amplified through their use of social networking sites to organise demonstrations. In the financial crisis, technological and market interconnectivity has meant that a negative rumour about debt levels in one relatively small country can lead to share prices collapsing worldwide.

The OECD, through its Futures Programme, conducted case studies of five types of events: financial crises, pandemics, cyber risks, social unrest and geomagnetic storms. The programme also identified five catalysts of global shocks.

The first is the trend towards concentration, whether of people, information or infrastructures. “The growing concentration of assets and populations perhaps increases vulnerability,” says Mr Stevens. Urban populations are growing. By 2025 there will be 40 megacities, 17 with populations exceeding 10 million. Dense populations place more people at risk in a natural disaster and enable certain diseases to spread rapidly. The same is true of transport. The bulk of international cargo is handled by only four air freight carriers organised around hubs in the US, Europe and Pacific Asia. The plume of ash spewed by an Icelandic volcano in 2010 paralysed air traffic across northern Europe.

Or take electricity. Tighter integration of cross-border transmission of electricity in the EU, US and Canada has increased the distance over which electricity is transmitted; longer transmission lines act as antennas during geomagnetic storms, raising the risk of major power outages. The 2003 blackout in the US caused certain retail banking operations to shut down for two days, endangered medical and emergency systems and transport of just-in-time delivery of food supplies.

Heightened mobility opens another risk. Again, this is not only in terms of people–migration, international tourism and business travel–but of goods and capital flows. The global financial contraction provoked the sharpest decline in trade since the beginning of World War II, but countries still managed to export over US$12 trillion worth of goods and $3 trillion of services in 2009. In fact, export growth has steadily outstripped production since the 1980s, facilitated by the growth of the Internet.

Heightened mobility means not just how far information can travel, but how fast. The use of supercomputers in high-frequency trading, in which hundreds of securities can be bought and sold within seconds, precipitated the “flash crash” of 6 May 2010. Traders’ stomachs were in their mouths when the Dow Jones Industrial Average plunged 7% in 15 minutes. High-frequency trading accounts for nearly two-thirds of US equities traded, and as much as a third in the UK.

Faced with such complexity, can anything be done to anticipate future global shocks? The modelling of complex systems offers some lessons. A system is “complex” when it exhibits characteristics that cannot be deduced from the observation of its parts. It would be unwise, for example, to judge whether a dog was docile or vicious merely by studying its anatomy.

Agent-based models (ABMs) are among the best tools available to anticipate the conditions that give rise to global shocks. With ABMs, risk managers run thousands of simulations to determine how a change of behaviour in its “agents” (say, people taking part in a street demonstration) affects the outcome. Demonstrators may be there for different reasons: to protest high unemployment, or the high cost of education, or even for the chance to smash shop windows. Whatever emerges from their collective action could never have been predicted from their individual behaviours.

The study of complex systems is often aided by the use of various maps. Besides physical maps (topological, demographic, etc.), useful in natural disasters, there are “conceptual maps” depicting less tangible systems, such as patterns of human interaction. An example would be the Internet, where user behaviour displays a characteristic called a “power-law distribution”. This means that users do not surf the whole of the net as is commonly thought, but cluster around a few sites, such as Google, Facebook or the BBC, and around a few personal favourite pages on those sites. Finally, “process” or “organisational” maps are used to visualise hierarchies, chains of decision-making and domino effects.

Of course, modelling is still a mathematical simplification of reality and is only as reliable as the data fed into it. One of the biggest hurdles to anticipating global shocks is that information lags behind technological capability. Advances in technology can also raise new barriers. The sophistication of models and maps can make governments and corporations nervous, as it exposes them to scrutiny. In some cases, uneasiness is justified. Much critical infrastructure is today in the hands of the private sector. While sharing data on those infrastructures is necessary to reduce their vulnerability, if information falls in the wrong hands it could be put toward nefarious purposes.

So co-operation is crucial. Withholding information could propagate a global shock. In a recent stress test of European banks, a simulation was run of a double-dip recession and stock market crash to assess banks’ resilience to a financial cataclysm worse than the collapse of Lehman Brothers in 2008. Despite current anxieties over sovereign default, many banks failed to disclose their full holdings of government debt.

Stress tests should be applied to all systems, not only the banking sector. Policymakers should also pay heed to redundancy, making sure that critical infrastructures such as water, electricity, telecommunications, etc., have adequate back-up systems. Mr Stevens points out that since the Fukushima nuclear disaster, the Japanese government has ordered severe cutbacks to energy consumption, and this has taken a toll on output. Sufficient back-up systems are necessary to keep the country running, but redundancy is expensive.

“Governments and the private sector should put more into monitoring and surveillance,” says Mr Stevens. To anticipate future global shocks, risk managers should create databases of vulnerable “hubs”, estimate the costs of disruption and consider how steps to prevent or buffer shocks increase risks elsewhere. This information should be shared under secured conditions among governments and operators of critical infrastructure. As for the Cassandras of the world, they should be reminded that global shocks are not necessarily bad; they stimulate creativity, leading to solutions that could avert future crises.

For more on future risks, visit contact Barrie.Stevens@oecd.org

References

OECD (2011), Future Global Shocks: Improving Risk Governance, OECD International Futures Programme, Paris. See also www.oecd.org/futures

Clarke, R (2002), “Risky future”, in OECD Observer No 235, December

 

©OECD Observer No 286 Q3 2011




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