If something happens more or less the same way for any extended period of time, the normal reaction of humans is consider that phenomena as constant and to largely filter it out. We do not then even try to capture new information about changes to that phenomena because our senses tell us that that input is “pure noise” with no signal. Hence the famous story about boiling frogs. Which may or may not be actually true about frogs, but it definitely reveals something about the way that humans take in information about the world.
But things can and do actually change. Even things that are more or less the same for a very long time.
In the book, “This Time It’s Different”, the authors state that
“The median inflation rates before World War I were well below those of the more recent period: 0.5% per annum for 1500 – 1799 and 0.71% for 1800 – 1913, in contrast with 5% for 1914 – 2006.”
Imagine that. Inflation averaged below 0.75% for about 300 years. Since there is no history of extended periods of negative inflation, to get an average that low, there must be a very low standard deviation as well. Inflation at a level of 3 or 4% is probably a one in a million situation. Or so intelligent financial analysts before WWI must have thought that they could make plans without any concern for inflation.
But in the years following WWI, governments found a new way to default on their debts, especially their internal debts. Reinhart and Rogoff point out that almost all of the discussion by economists regarding sovereign default is about external debt. But they show that internal debt is very important to the situations of sovereign defaults. Countries with high levels of internal debt and low external debt will usually not default, but countries with high levels of both internal and external debt will often default.
So as we contemplate the future of the aging western economies, we need to be careful that we do not exclude the regime changes that could occur. And which regime changes that we should be concerned about becomes clearer when we look at all of the entitlements to retirees as debt (is there any effective difference between debt and these obligations?). When we do that we see that there are quite a few western nations with very, very large internal debt. And many of those countries have indexed much of that debt, taking the inflation option off of the table.
Reinhart and Rogoff also point out the sovereign default is usually not about ability to pay, it is about willingness to make the sacrifices that repayment of debt would entail.
So Risk Managers need to think about possible drastic regime changes, in addition to the seemingly highly unlikely scenario that the future will be more or less like the past.