A properly designed tail risk hedge cost effectively mitigates risk. In March of 2020, the US government shut down a small portion of the US economy, when it mandated risk measures to protect against the spread of COVID-19. The predominant sectors that were affected were the travel industry, in order to stop the spread from other countries, and any business relying on face-to-face interaction: restaurants, crowded offices and other workplaces, movie theatres and many more.
Tail risk hedge helps businesses and consumers
Both the US economy and the US government were blinded by the unknown fears of the pandemic and wanted to do anything to remove tail risk. By their logic, any possible option to mitigate the fallout was on the table. In such an uncertain economic climate, politicians did not want to hold individuals or businesses accountable for failing to protect against unforeseen risks. Over-levered businesses and consumers who were ignoring tail risk likely would have failed completely and made even bigger losses without financial support from the government.
As the lockdown-induced credit markets went into a tailspin, the Federal Reserve and US Congress quickly went into crisis fighting mode. Drawing on the interventions from 2008 – which in their minds were successful – the Federal Reserve calmed and steadied the credit markets allowing businesses to borrow what they needed to financially survive until the economy recovered from the disaster which was COVID-19. Congress began to issue trillions of dollars worth of new debt. This money would be sent to both panicking consumers and businesses alike. The Federal Reserve happily monetized that debt, which meant it looked to be a free lunch. To make things worse, mass debt moratoriums were enacted.
The rationale for the extreme money printing was that high unemployment and low demand created deflation. Ex-Treasury Secretary Lawrence Summers argues that the pandemic isn’t the only reason for our record levels of inflation – you can read more here.
Deflation could be countered with extreme spending and low interest rates. But was anyone questioning if this actually made sense? If the economy was not affected by high unemployment and low demand, and money could be printed quickly and easily, then why is anyone producing anything or working for a paycheck in the first place? Who wouldn’t like to quit working and have the government send us spending money so we could all live the lives we’ve dreamed? Using an ineffective and costly tail hedge did not make economic sense at all – and was ultimately a serious and fatal mistake by policymakers.
Now, we are faced with a new risk. Inflation is at levels not seen since the great inflation of the 1970s – another era fraught with political and economic tension. The peak of unemployment was around 11% when Paul Volcker raised interest rates into the teens during the 1970s and early 1980s. In today’s world, taming inflation will bring a host of new risks, including falling asset prices, potentially higher unemployment, and increased debt burdens for the public – all when our economy is trying to get back on track.
The risk mitigation and tail risk hedge that the country needs to be effective and cheap is proving to be anything but. When regarding long term factors and projecting how our damaged industries can recover in the next ten years, the cure was worse than the disease!
Over the next couple of months, volatility will rise as the Federal Reserve withdraws part of our costly tail risk hedge. Inflation needs to be brought down to appropriate levels or the economy will not function properly. But the stakes are high, unemployment could rise, asset prices could fall and political careers could disappear.
Will policymakers and the public demand a rethink of current risk management approaches? I am not holding my breath.