Political risk has come home, and we must combat it

The past decade has upended my profession almost entirely. I work in political risk, and my job is to advise companies how to manage political and economic instability.

A coup in Turkey, sanctions against Russia, unrest in Venezuela, debt default in Argentina – such risk events are the bread and butter of political risk analysts such as myself, and of political risk underwriters who offer insurance policies against such perils.

Until recently, these risks occurred almost exclusively in emerging markets such as Turkey and Russia. No one ever asked us to analyze the politics of the Netherlands. No one ever tried to buy political risk insurance against civil war in Canada. To have done so would have been preposterous.

Indeed, the absence of political risks from the “advanced economies” of North America, Western Europe and Japan was almost definitional. The certainty that politics would not impact business operations was what made these countries safe havens for investment; it was part of the formula that enabled these countries to become, and remain, rich.

The Eurozone crisis changed all that. Greece’s sovereign default in 2012 was the first default by a rich, industrialized country since World War II. (And even during World War II, defaults were rare.)

It was an event that most people had considered inconceivable. For Greece, the economic costs of political uncertainty turned out to be enormous. Perhaps hoping to stave off cognitive dissonance, in 2013 Morgan Stanley Capital International duly reclassified Greece as an “emerging market.”

Such risks are not limited to Europe. In 2011, the US lost its AAA debt rating from Standard & Poor’s, in large part because Republicans in the US House of Representatives had attempted to use the threat of a US sovereign debt default to wrest concessions from the White House.

It was an unprecedented loss of status: not since 1860, when Standard & Poor’s was founded, had the U.S. been downgraded. The U.S. AAA rating that had survived two world wars was undone by political polarization.

Today, rankings of countries by risk level have an upside-down quality. In BlackRock’s sovereign risk index, Chile and Taiwan currently rank better than the UK; Peru and the Philippines outrank France.

Watching the current US election cycle, one wonders how bad this situation might become. Friends now routinely ask me if they should sell everything and move to Canada before November.

They are joking, of course. But they joke with growing unease, as they have discovered via observation of the Brexit saga – another alarming example of political risk – that one should not wait until after the vote to make their move.

In theory, my friends have little to worry about. American democracy is replete with what we in the political risk profession call “veto points.” One of the more robust findings from academic research on political risk is that the more veto points a country has, the less risky it tends to be.

In the United States, the checks and balances of the branches of government, as well as the division of power between the federal, state and local levels, create numerous veto points. As a result, unwise policy proposals tend to be vetoed before they are implemented.

And yet, as a political risk analyst, I do not like the way things are going. Recently, even political violence risks seem to be escalating in advanced economies.

In the past few months, threats from home-grown terrorism have materialized in Europe. And in the US, we have witnessed protests, and occasionally violence, in response to perceived police brutality.

To be sure, riots are not unusual, even in advanced economies. Indeed, the US saw a wave of far more dramatic “race riots” in the 1960s, peaking in 1967 and 1968. This unrest died away as civil rights legislation and court rulings addressed some of the underlying concerns.

But imagine a victory by Donald Trump in the current charged environment. Scenarios in which today’s protest issues escalate and go unresolved for some time are within the realm of possibility.

One might hope that political leaders will recognize the rising stakes, and begin to modify their own behavior. One might hope that they would choose to refrain from making threats of debt default, for instance. One might hope they would avoid language that might incite racial tensions.

But I would not count on it. About fifteen years ago, when I worked for Aon Trade Credit, a political risk insurance broker, we downgraded Venezuela to the lowest possible political risk rating.

Venezuelan President Hugo Chavez responded by aggressively pretending the problem did not exist. “What political risk is there in Venezuela?” he said. “I don’t see any.”

One might think that at some point he would have flinched, but he never did – fifteen years on, Venezuela is engulfed in a political, economic and humanitarian crisis largely attributable to Chavez’s spectacularly irresponsible policies.

I do not want to be alarmist. Even the most populist of today’s crop of leaders and candidates appear to be nowhere near as reckless as Chavez.

But history suggests that we should not wait for politicians to take the initiative. It is up to civil society to exert pressure to address mounting problems of political risk.

We should advocate for policy reforms that can mitigate the impact of political instability on policy and the economy – for instance, revising rules so that the debt ceiling is no longer a tool politicians can use to bludgeon their opponents.

We should also advocate for policy reforms that hold politicians to account. For instance, banking regulations still operate on the fiction that government debt is “risk-free.” This a laughable proposition given events in Greece; moreover, it insulates leaders from the economic consequences of their actions.

Devising and implementing policy measures that reduce political risk will be a challenge. Indeed, when markets are already unsettled it is tempting to paper over the problem.

But that was Hugo Chavez’s approach, and it has not ended well. Political risk has come home to the advanced economies. Political risk has cost the US its AAA rating; it has delayed recovery in the Eurozone for years; it is currently threatening to push the UK into recession.

If we continue to ignore the existence of political risks in advanced economies, it may be the US or UK that is next downgraded to “emerging market” status.