<>This is a commentary of a Treasury document available at
The living standards framework is at:
I was asked to do this comment in a hurry. Some of the thinking is as superficial as that of a university professor (as we say in the trade).
Keywords: Governance; Statistics;
Introduction: The Pentagon
The context of this paper is ‘the pentagon’ which is a diagrammatic representation of the New Zealand Treasury‘s living standards framework. Each vertex summarises one of the outputs which Treasury uses to assess whether its policy recommendations contribute to improving New Zealand’s living standards. They are
– economic growth
– sustainability for the future
– increasing equity
– social infrastructure
– managing risks.
In my opinion the way to think of them is that they summarise the issues that the minister they are advising might want to raise, and hence the framework becomes a checklist for each Treasury analyst when evaluating policy. Of course each minister will give the objectives (the vertices) a different weighting/significance. But it is not for the Treasury to second guess the minister. Rather it needs to be prepared to respond to the minister’s preferences.
(There is a weakness in this interpretation however. Some ministers – all ministers to some extent – with be concerned about the quality of output. This includes
– the impact of policy on the non-market sector
– and, as John Stuart Mill put it, ‘it is better to be a to be a human dissatisfied than a pig satisfied; better to be Socrates dissatisfied than a fool satisfied.’ (Since this is an issue which economists often overlook let me illustrate. The 1989 report on Post Compulsory Education and Training said that policy should not distinguish between education and training. In doing so it argued that educational policy should ignore the quality of the outputs of the educational sector. That approach has characterised most public policy since. Whether it has achieved that objective – that the pigs are happy – may be debated.
In my experience some ministers have been concerned about at least some aspects of the quality of life in New Zealand. Without that notion in its living standards framework, the Treasury is not well prepared to respond to this concern.)
This paper is about the managing risks component of the living standards framework – one of the vertices of the pentagon (or hexagon, if quality is added as a living standards objective).
The Treasury Risk Management Document
The need for a Treasury document on risk management was well illustrated by the following from the just released Financial Statements of the Government of New Zealand. ‘EQC expects to have the necessary financing to meet its liabilities as they fall due over the next twelve months’. It is a great comfort to those living near the Wellington Fault that there is no risk of a major earthquake this year.
But how is the government to take into consideration that some things are less certain than the impossibility of a major earthquake in Wellington? This Managing Risks document might be thought as a step towards addressing the issue. However, I am uneasy about its approach to managing risk as a vertex on the living standards pentagon (while accepting that it may be a useful document for Treasury officials to have for management purposes). The other four vertices are social outputs, each intended to be a valuable object in itself. Managing risk, as presented here, is much more of an input – a management process.
I shall explain later about how one might redefine the point as an output, trying to reduce certain sorts of risks that we all face – accident, aging, crime, food poisoning, ill health, unemployment and so on. But this is not what this document is about; it is a management document.
Describing the document as a ‘short guide’ implies that there is a long guide. I have not seen it, so necessarily these remarks are preliminary.
The Meaning of Risk
First, I need to tease out the meaning of ‘risk’. I am a bit old fashioned with a Knightian view. The good Chicago professor distinguished between risk and uncertainty: risk is what you can quantify, uncertainty is what you cant. As it happens, a particular case often locates itself ambiguously between the two. You may know something about the probability distribution of the event but not with a sufficient degree of precision. In which case it may not be possible to apply the standard risk management strategies. On the other hand, if there is some knowledge about the distribution, the standard response to uncertainty may not be the most efficient approach in the case.
People thought they found a way around this by the application of Bayesian probability theory. If the risk is not fully quantifiable then – to quote a past prime minister – you ‘make it up’, or rather the market makes it up. The danger of such an approach was well-illustrated in the Global Financial Crisis. Models – more highly strung than those that use a catwalk – were deficient in key parameters, so the users made them up. When the models were stressed by the world as it was – rather than as their managers hoped it would be – they collapsed and the financial structures on which they were based collapsed with them.
At least one conclusion from this rather calamitous farce is to be aware that there are ‘known unknowns’, and not to transform them into ‘known knowns’ by the use of fictitious parameters or untested theories.
The Knightian approach provides a slightly different framework to the ‘pokie machine’ on page 3 of the paper we are looking at. To simplify it says
– identify all the sources of uncertainty;
– select the ones which are important. Typically that means they have a high probability of happening, or the cost when they happen is high;
– try quantifying the distribution’s parameters of each case. Where that can be done adequately this is a case of risk, where it cant it is a case of uncertainty.
If it is an uncertain case there are fewer options to deal with it. The most obvious is to reduce the risk by mitigation – perhaps a mini-max strategy. This uncertainty may not be the same thing as resilience, which I discuss later.
If the case is risk there may be an additional option of insurance type responses. I add to my earlier warning not to make up parameters, the additional caution to be careful of thick-tailed distributions. The conventional approach is to estimate a mean and variance from a sample and apply it to a normal (or related) distribution. However the distribution in real life may have thicker tails than the normal distribution. As Benoit Mandelbrot observed
According to portfolio theory, the probability of these large [stock price] fluctuations would be a few millionths of a millionth of a millionth of a millionth. (The fluctuations are greater than 10 standard deviations.) But in fact, one observes spikes on a regular basis – as often as every month – and their probability amounts to a few hundredths. …The discrepancies between the pictures painted by modern portfolio theory and the actual movement of prices is obvious.
There are two warnings here. First, dont assume that the world is (near) normally distributed; second, portfolio theory does not work where it isnt. This seems to be a part of the failure of the financial models which contributed to the Global Financial Crisis. I mention this because where there is a thick-tailed distribution one tends to be forced back into treating the event as uncertain.
One option available for risk management – not mentioned in the paper – is risk shifting. That, of course, is what insurance is about, where the risk is shifted to others more willing to take it.
There is a more insidious form of risk shifting, where the risk or uncertainty is shifted surreptitiously (or compulsorily) onto others. That is what happened in the 1980s when a lot of risk was shifted from the public sector (that is the taxpayer) to the individual. For example, government superannuation was converted from a defined-benefit to a defined-contribution scheme so the risk of the level of payout is the retired civil servant’s rather than taxpayers’.
There are many other examples; today is not the place to list or analyse them. I mention the phenomena as a practical illustration of risk shifting,
The Importance of Applications
I have one other caution about the paper before finishing with it. It has few practical examples and applications. This is a short guide and I have not seen the long one which may contain them. So let me illustrate the issue by the Regulatory Institutions of the Productivity Commission. Despite being a long paper it too lacks examples and applications. As someone who is working, and has worked in, a number of regulatory areas, I found it of little value, irrelevant to the practical intricacies I am concerned with. One is reminded of the economist who had read the kama sutra a dozen times but had never been out with a woman.
This paper faces the same danger. Even in the day since I was asked to give this presentation I have been alerted to the risk dimension in a number of topics with which I was dealing. In no case did I find the paper of much help.
So I would urge that if it is decided to continue the focus on ‘managing risk’ as a managerial input rather than a living standards output, the redraft pays more attention to examples.
(At this point one recalls the wisdom of Alfred Marshall applying it to management principles rather than mathematics:
[I had] a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules – (1) Use mathematics as a shorthand language, rather than an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in (4), burn (3). This last I did often.
Risk Management as an Objective
But is there a kind of risk management as an output of living standards – or an objective of attaining them – rather than just risk management as an input for public sector management? Whatever its strengths for management purposes The Short Guide to Managing Risks does not sit happily with the other four vertices of the pentagon which are outputs, each, in their own way, contributing to higher living standards. Can we recover the notion of risk to make it an output?
In fact government interventions often involve risk management aimed at raising the living standards of its people. In New Zealand’s case a major example is the welfare state.
Now it is not obvious that the state should eliminate all risk and uncertainty in people’s lives even if it could. Moreover it cannot, even if it wanted to. Very often it only reduces the risk in one person’s life by shifting it onto others – typically taxpayers. Trying to get a better balance was one of the objects of the policy changes of the 1980s. We can argue whether a better balance was attained, but I am eschewing that today. My point is that this is a proper matter to be included in policy analysis, and that the consequential decisions will affect living standards. I suggest that is the proper approach to the ‘manage risk’ point on the pentagon.
Without such a vertex there is an incentive to risk shift away from the government, even in circumstances which would result in a general reduction in living standards. Indeed it is unclear how the welfare state, whatever its form, fits comprehensively into the pentagon framework. You might suggest that the ‘increasing equity’ point on the pentagon encompasses the welfare state. I am at a disadvantage because I have not seen the relevant paper. My guess is that the welfare state still needs a separate dimension – vertex on the pentagon – discussing risk and uncertainty.
(In thinking about these issues one piece of research is not unimportant. Under certain experimental conditions it can be shown that people (Americans actually) trade off the possibility of a $1 loss against a $2 gain on average. I have never seen the implications worked through for public policy; but it suggests that some policies can improve living standards.)
The Role of Resilience
An earlier draft of this paper confused the risk vertex with resilience. Resilience has recently become a popular term following the failure of some buildings during the Canterbury earthquakes (although the environmental movement was concerned with it long before). Its popularity means it tends to be used casually without a clear analysis.
I use ‘resilience’ here to mean the ability to cope with an external shock. From the perspective of an economist there is a host of such shocks, including natural ones like earthquakes, numerous external offshore shocks (much of my research as been studying these) and shocks from new technologies (which may, or may not, be beneficial economically but often put additional strains on other dimensions of society). How to handle self-induced shocks is unclear.
Such lists are not analysis, although necessary if one is going to do the analysis in the context of the real world. However, the point to be made here is that resilience is something which we should be concerned about – a proper matter for public policy. Indeed one might argue that much of what Rogernomics was about was increasing the resilience of the economy (with the hope that everything else was sufficiently robust/resilient to be able to cope with the substantial self-generated shock the changes induced).
This is straying outside the original remit of the paper. So I want to make but two further points. The first is to mention Murphy’s principle: ‘design the system on the assumption that what can go wrong will go wrong.’ (This is, incidentally, not the same thing as Murphy’s Law that ‘anything that can go wrong will go wrong’. It is a design principle for managing risk and uncertainty). It is a minimax strategy, which led me in an earlier version of the paper to confuse resilience with risk.
The second point is to make the distinction between the two. Resilience is not really about living standards. It is about an attractive (one might say necessary) characteristic of any system. As such it belongs to a group of design issues which the living standards pentagon assumes – human rights and the rule of law are companions. In my view they should be included at the centre of the pentagon (or hexagon if quality is included as a relvant output).
However, as I have already argued, we can manage risk directly to improve living standards. So it cannot be the same thing.
In all this I affirm that in the living standards approach there is a need for a vertex covering risk and uncertainty (and security) as an integral part of living standards. One cannot avoid them, but sometimes collective actions can reduce their impact for the benefit of everyone.