A Fat Tail World – Part 3

By Ian Bremmer

At a moment when the financial crisis and its deepening impact on domestic economies around the world are dominating the headlines, political risk is becoming a more immediate concern for both the health of global markets and the political stability of dozens of countries. There are three broad categories of fat tail risk in today’s environment.

First, there are geopolitical risks, the traditional threats that flow from the potential for international conflict. Some are a direct result of greater volatility in particular countries and regions. Pakistan faced serious political, economic, and security problems long before the global financial meltdown made things worse. Now the intensifying political conflict between President Asif Ali Zardari and opposition leader Nawaz Sharif threatens to come to a head in the streets of Islamabad. Others of these risks develop because too few people are paying attention. For example, the potential spillover effects of drug wars in Mexico are creating market risks that many have overlooked.

In fact, a look at the major geopolitical hotspots in the world today suggests that the only real improvement over the past 12 months has come, ironically, in Iraq. Unpopular governments and growing security threats leave Afghanistan and Pakistan in troubled waters. From the anxiety emanating from an increasingly troubled Moscow to the prospect of conflict between Israel and Iran — the traditional forms of political risk are on the rise this year. Even Iraq has unresolved conflicts that could yet generate a spike in violence and new market-relevant political and security problems in the months to come.

Second, there is the risk produced by a shift in economic power from capitals of finance to capitals of political power, as fast deteriorating economic conditions persuade political officials around the world to take on decisions normally made by markets. President Obama has warned more than once that if the executive and legislative branches of the U.S. government fail to act quickly and effectively to rescue the American economy, the United States will face an economic catastrophe. In other words, whatever bankers and business decision-makers do, whatever plans the automakers draw up, however many hundreds of thousands of layoffs come from other sectors of the U.S. economy, it’s Washington, not New York, that will determine the country’s economic future.

This is not simply an American trend. News of large-scale state spending projects meant to create jobs and jumpstart growth in developed and developing states all over the world will ensure that domestic political factors will drive market outcomes on a scale not seen in a very long time. This trend will create a distinctly different set of economic winners and losers than markets would generate.

Third, the global recession will trigger its own political instability, and the fallout from a range of second-order risks will, in many cases, overshadow the recession itself in severity and breadth of impact. U.S. Director of National Intelligence Dennis Blair has identified political instability generated by the financial crisis as the largest threat to U.S. national security in 2009. A sharp economic downturn in emerging markets with embattled political leaderships and relatively weak middle classes — states like Argentina, Ukraine, and Turkey (and even some developed states, like Greece or South Korea) — leave these countries and others like them especially vulnerable to political turmoil.

In short, it’s been decades since political risks have played such a significant and direct role in the performance of global markets. That latter point is going to be increasingly obvious — with enormous implications for investors and policymakers alike — over the course of this year. Managing the most dangerous and least predictable of these risks is, in a nutshell, what The Fat Tail is about.

For a closer look at The Fat Tail: The Power of Political Knowledge for Strategic Investing, here’s a useful link: www.fattailbook.com.