Peter Jones: Independence an unknowable risk

Picture: TSPL

Picture: TSPL

Scotland’s constitutional future could yet be decided by the force of a ‘black swan’ style unlikely event, writes Peter Jones

Indignation flared recently when newspapers discovered that a risk assessment of Scottish independence had been compiled by the Scottish government’s civil servants but the SNP administration was refusing to publish it. Attempts to extricate it from Alex Salmond’s filing cabinets are unlikely to succeed, but if they do, the document might make surprising and uncomfortable reading for both Unionists and Nationalists alike.

One reason is that risk is extremely difficult to evaluate. Just ask anybody working in financial services. In the 1990s and early 2000s, bankers (especially the investment variety) developed extremely sophisticated ways of working out the risks involved in various transactions. Mathematical modelling was particularly prized. Ingenious algorithms and complex probability analysis were deployed to estimate down to several decimal places the chances that a deal could go sour. The people who devised them, the “quants” as they became known, would tell the decision-makers that, having crunched all the numbers and weighed the probabilities, there was an x.x per cent chance money would be lost, but a y.y per cent probability of gain.

It can now be said, with 100 per cent certainty, that this was a complete load of old cobblers. If it wasn’t, banks such as Bear Stearns and Lehmans would never have collapsed, and RBS would still be private, churning out huge profits. But to our cost, and that of our children, we know that risk quantification was about as reliable as astrology.

A fundamental factor in this was the assignment of probability to the occurrence of unlikely events, or “black swans” as they have become known after the book of that title by Nassim Taleb, and how a black swan event might affect an investment.

One of the basic models of financial risk assessment is known as “value at risk” or VAR for short. It relies on the idea that history repeats itself. So you look, say, at a share price’s history, list all the daily movements over a period of time, and work out what the maximum and minimum movements are. From this you can then work out what is the probability of losing (or gaining) money on buying those shares and owning them for a specific period of, say, 30 days. But then, during that period, how likely is a black swan event such as a major war in the Middle East, or a big collapse/price spike in a particular market?

These are usually given probabilities of one in a hundred, or a thousand-year events. But much like one-in-a-hundred-year floods, these apparently rare events seem to be happening more frequently. In the last three decades, there have been two Middle East wars, two sovereign debt defaults, three oil price spikes, two corporate bond crises, three financial crises, and half a dozen crises in various other markets, not to mention the 9/11 attack on the World Trade Centre.

All of these, at least until the daddy-of-them-all banking crisis in 2008, were thought to be one-in-a-hundred or thousand-year black swan events. And pretty much all of them caused unprecedented price swings way beyond anything that had previously happened. Worst of all, the explosion in collateralisation of mortgage debt, which was supposed to have spread and therefore reduced risk, had the opposite effect. So complex were the trades, nobody knew who had what risk and it was therefore assumed in the general panic that risk was everywhere.

The lesson? It is that although you may think you can come up with a fair estimate of the risks of independence (or staying in the union), you cannot be certain about them. And, as with the collapse in house prices beginning in 2007-08, while there may be forecasts of this or that event happening, nobody can tell you when it will occur. But of course, these are financial and economic risks and it might be argued that political risks are not the same. Indeed they are different in character, but they are also equally difficult to determine.

One incalculable effect is how personalities will interact with each other. An example close to home has been the formation of the Conservative-Liberal Democrat coalition. Given the mutual distaste that the two parties have had for each other, the insults traded in the election campaign, and the fact that the Lib-Dems are more centre-left than they are centre-right, it was not surprising that no serious commentator forecast that the two parties would coalesce or that they would succeed in making it work.

A key factor seems to have been the unexpected degree of shared interests and even mutual warmth that seems to exist between David Cameron and Nick Clegg. With hindsight, Gordon Brown’s inability to form such relationships with all but the very closest in his circle was also the overwhelming fact that ensured he and Labour were left out in the cold.

A more striking example is the break-up of Czechoslovakia. In 1992, there was a general election for the country’s federal government. No party, apart from a small Slovak nationalist party which didn’t get anywhere, proposed dissolution of the federal state to create the Czech and Slovak republics. Yet within two weeks of the election, talks to do exactly that were announced and were more or less completed seven months later. The prime reason for this was that the Czech leader, Vaclav Klaus, and the Slovak leader, Vladimir Meciar, couldn’t stand each other. They liked even less the thought of having to work with each other in a federal government. But their sway with their electorates (who were admittedly more used to dictatorship than the workings of democracy) ensured this completely unheralded constitutional earthquake occurred. The lesson? How personalities interact can trump rational calculation of likely political outcomes.

The more general lesson is that, in deciding whether Scotland is better off staying in the union or quitting it, all sorts of risks and uncertainties, both positive and negative for both sides of the debate, will come into play. Deciding whether they are real or not is more a subjective judgment than anything that can be calculated. And even assessments of these issues may be swept aside by personality politics, which may be animosity-driven clashes or unexpected mutual-interest alliances. Though polls currently suggest the pro-independence cause will lose, unforeseeable black swans and unsuspected love-hate matches mean that to conclude that now is risky and uncertain.




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