Policy, risk and you

With savings rates low and likely to remain so for a long time, the question arises: is economic policy causing investors to take on more risk? The answer is yes - partly by design, and partly by accident.

The Bank of England wants us to take more risk, because doing so is one of the ways in which it hopes that loose monetary policy will boost the economy. In explaining why it has undertaken quantitative easing (QE), the Bank says it hopes that investors will use the cash they get from selling gilts "to purchase other assets, such as corporate bonds and shares". Similarly, one traditional route through which low interest rates are intended to stimulate the economy is that they encourage investors to switch out of safe cash and into equities or corporate bonds, thus reducing companies' cost of capital and encouraging them to spend more.

In this sense, encouraging risk-taking isn't a bug of policy, but a feature.

Equally, to the extent that QE adds to inflation risk, this is also a feature of policy; the point of QE is precisely to increase inflation, albeit not to the levels inflation-worriers expect.

However, one could argue that this isn't really an increase in risk at all. If central banks hadn't undertaken QE, it's likely that the world economy and share prices would now be weaker. Investors would therefore have been exposed to greater risk - of job loss, business failure and falling share prices. Perhaps, then, QE has changed the risks investors are exposed to, and not merely increased them.

There are, though, other ways in which economic policy is adding to the risks we face.

You might think that the most obvious of these is simply that fiscal austerity is increasing our risk of job loss, which in turn makes it riskier to hold shares because of the danger that these will fall at the same time that we lose our job.

This is true - though it might be justified by the possibility that austerity raises long-term economic growth by increasing economic volatility or reducing the share of the state in the economy. But I'm not sure how significant it is, simply because the risk of job loss is quite high even in normal times. Jonathan Wadsworth of Royal Holloway University and colleagues show that since 1975 the average worker in an average year has a 3 per cent chance of losing their job. This rises to around 5 per cent in deep recessions such as those of 1981, 1991 or 2009. With even the government's harshest critics not accusing it of causing a deep recession, the additional income risk to the average worker from austerity is small.

But there's a second way in which policy is adding to risk, highlighted in a recent paper by Yale University's Gary Gorton. It's that the government is not supplying sufficient safe assets, government debt, to the private sector.

Government debt, he says, is not just a burden but an asset. Top-quality government bonds can be used: to diversify stock market falls; to provide collateral and so facilitate borrowing for useful projects; and as a liquid asset that can be sold in times of distress thus preventing fire sales of other assets. In these ways, government debt can stabilise the economy. Professor Gorton points out that financial crises "are more likely when the quantity of outstanding US Treasuries is low".

And here's the problem. Thanks to QE, the supply of gilts to the private sector hasn't changed much since the recession. If we exclude the £374.9bn of gilts owned by the Bank of England, public sector net debt is now 46.9 per cent of GDP, which is only slightly more than the 44.5 per cent we saw in March 2009.

In this sense, investors are being starved of safe assets, and are having to pay a high price to buy the insurance that gilts offer against recessions and falling share prices.

To see all this another way, imagine we'd had a different policy mix in recent years, with looser fiscal policy and tighter monetary policy. This would have given us higher short- and long-term interest rates and hence more attractive safeish assets. This surely tells us that economic policy has added to risk.

There's another way in which it has done so - one for which the last government is as culpable as the current one. Governments have consistently failed to improve institutions to help people manage risks which the private sector does not help us with. Take three examples.

■ The unknowable possibility that we might need an unknowable amount of social care in our old age makes optimal financial planning almost impossible. But governments have not solved this problem, even though Andrew Dilnot has showed them how.

■ Millions of people are exposed to house price risk. Young people face the danger of prices rising, thus preventing them 'getting on the ladder', while older folk face the risk of prices falling just before they trade down. In theory, this problem could be solved by house price futures markets, which older folk sell to younger ones. But neither the private sector nor governments have created an active market in these.

■ Economic policy cannot prevent recessions. But people could in theory insure themselves against them by using GDP-related securities which rise in price as GDP grows and fall as GDP falls. But again, governments have failed to help the private sector develop these.

All this vindicates Alan Blinder's famous quip that "economists have the least influence on policy where they know the most and are most agreed". Financial innovation is a device whereby banks rip off customers and taxpayers, not a way to help us manage risk properly.

It is, then, pretty clear that economic policy is causing us to carry more risk than we need to.

What's not so clear, though, is how big a problem this is. It could be that the public is so tolerant of risk that it just doesn't mind this extra burden.

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