Systemic Risks, ItalEXIT and the Placebo Effect

The idea of Italy leaving the Euro and the European Union is being exploited by danger-thirsty politicians in the light of the upcoming elections on September 25-th. This project appears reckless to any fair-minded person with a minimal dose of unsentimental realism. We have analysed this in a recent article. In this article we wish to focus more on the systemic aspects of a hypothetical ItalEXIT. Those economists that focus their analyses of ItalEXIT on its impact on Italy and Italy alone, resort to evasive and euphemistic arguments that exploit the reservoir of credulity of the uneducated public.

The departure of Italy from the EU is not something that can be considered seriously and realistically unless architectured from a systemic perspective. No country functions alone. Today, everyone is connected to everyone else. Our analysis of the Development Indicators published by the World Bank – there are nearly 400.000 of them – show that the World’s degree of globalisation is around 70%. This means that World is a system in which 70% of all the possible interdependencies are already there. The system is extremely dense. This is why crises and contagion propagate with the speed of the internet. To think that ItalEXIT can be engineered by focusing exclusively on the economy of Italy is not only a gross misapprehension, it is also arrogant and conceited.

Italy is a G7 country and is one of the hubs of the European and Global economy. Italy boasts the second largest manufacturing industry in Europe after Germany. Surely, in a post exit scenario the damaged supply chains which link Italy to its partners, would cripple everyone’s economies. Italy’s partners would not want that to happen. They will not allow that to happen. It would put the entire system at risk, not just Italy. In essence, the problem is not only immense, it is also predominantly systemic.

The people who really understand systems and systemic aspects are engineers, certainly not economists. In 2008 systemic risks became popular but since there have been no tools to address them seriously. A simple example. Every year, Central Banks run the so-called “stress tests”, in order to assess how banks would resist hypothetical and unfavourable conditions. This is done on a one-by-one basis. At the same time, economists and politicians, who are exigent for uncritical praise, speak proudly of the dangers of systemic risks but nobody is concerned with actually running a stress test of a system of banks! In September 2013, Ontonix has published a paper in BANCARIA – the journal of the Italian Banks Association, ABI – in which we analyse systemic risks of ecosystems of EU and US banks, measuring their respective resilience and identifying which banks would put the whole system at risk. We do not know of any similar study.

Let us now illustrate, with a very simple example, the importance of a systemic approach by analysing a commodity trading company. Let’s start with a conventional approach and look at monthly Profit & Loss Statement. The data is reported below.

The resilience of the company’s business based on this data is 75% and its breakdown into components is shown below:

Let us now make this analysis a little bit more systemic. The company uses different currencies to purchase and sell commodities in different countries. So, let’s take into account the prices of these commodities as well as currency exchange rates and see what happens. The augmented data – containing the said exogenous variables, i.e., variables that the company cannot control – is shown below.

The external variables – which add a very modest systemic dimension to the analysis – are highlighted clearly.

The resilience now is down to 62%. In other words, not embracing variables that are beyond the company’s control, produces a placebo effect, giving a distorted and excessively optimistic reflection of the situation. The new breakdown of resilience is now the following.

This now shows how over 50% of the company’s resilience – risk exposure – is driven by external variables, i.e., variables which are not under the control of the company (or anyone else for that matter). In fact, the exchange rates of USD versus JPY, INR and CHF alone drive over 17% of the resilience of the business. Should any of these currencies suffer a disruption, it would affect the business significantly.

What this very simple example shows is that a highly localized analysis will almost always induce unjustified optimism, by projecting a false image of control, resilience and stability. Expanding the analysis to embrace other dimensions – for example macroeconomic parameters, unemployment, interest rates, commodity prices, stock market indices or currency exchange rates, not to mention some basic fundamentals of one’s key clients and suppliers – makes it more realistic, credible and relevant. Unfortunately, in doing so one loses the pleasant placebo effect which a localized analysis induces.

In the case of a hypothetical ItalEXIT, any analysis limited to Italy and its economy, neglecting the other 26 economies (not to mention the US, or China) will surely provide an optimistic, palpably false and distorted picture.