What Seems to Work

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The geopolitical and the merely political, the credit-worthy and the less so, all reflect human behavior. Human nature often trumps planning, but sound institutions (when they’re present) facilitate positive sum outcomes and the behaviors that engender those outcomes.

And that’s important: positive outcomes are mutually beneficial – no one is left holding the short end of the stick. For the global risk taker, being able to assess when outcomes can be positive sum – when both you and I benefit from the transaction – may be the rub. It can mean repeat business, after all.

The world is not ideal, though, and institutions can be unsound or brittle, and behaviors inconstant. It’s a truism, but due-diligence remains important, especially now.

Many things can circulate over from pointy-headed types and their discussions in the faculty lounge. Weird public policy prescriptions to name one. But, from academia, I have found it especially useful to plumb the works of Daron Acemoglu (an economist at MIT) and James Robinson (he, presently, a political scientist and economist at the University of Chicago).

As MMD contemplates the updating of its Geopolitical Risk Framework composite score, the collaborative writing from these two scholars comes readily to mind. The two academics wrote Why Nations Fail: The Origins of Power, Prosperity and Poverty (UK: Profile Books, 2013) and then The Narrow Corridor: States, Societies and the Fate of Liberty (New York: Penguin Press, 2019).

The first book explores and details the importance of institutions regarding how well human beings have been organizing themselves to create and benefit from the fruits of societal living. To Acemoglu and Robinson, institutions – those agreements that determine how we behave in the social context, that is, in the political, economic and legal realms where we interact – underpin successful societies and, by implication, ones often better suited for economic growth and wealth creation.

The second work from Acemoglu and Robinson looks at the dynamic between society and the state. An enlightened balance is optimal. Both state and society engender institutions. Inclusive institutions allow for the state in its enlightened role as a source of public goods; a means for public discourse, deliberation and policy formation; and a useful set of guard rails defusing the potential anomie of a buoyant society.

A society encompassing inclusive institutions (when all are enfranchised – in a word) allows for more dynamism, creativity and adaptive change.

When things are wholly corrupted and skewed, the consequences are extreme: a state that governs to the exclusion of society means despotism; a society without the deliberations and law of the state means anarchy. When flawed institutions, underpinning both, are corrupted from rent-seeking and elite capture, everyone loses.

Flawed institutions subvert wealth creation and general prosperity, according to Acemoglu and Robinson. Flawed institutions are biased and “extractive”, favoring incumbents and insiders vis-à-vis the general population. Among other things, incumbency prevents change and can hinder innovation. There is no creative destruction, but rather “stasis” – a “lock” incumbents exert to secure advantage.

By contrast, institutions that are “inclusive” are impartial and are constituted for the benefit of the entire society – not just insiders; they thereby generally enjoy broad based “buy in” and better resilience. Inclusive institutions work: they are transparent, residents have confidence in them and observe them. Contracts can be struck with confidence, and risk premia can narrow.

There can be creative destruction because residents have confidence in society’s impartiality. Vagaries of luck and circumstance may mean I am “down” this time but I can come back “up” – my sense of purpose, initiative and talents will be allowed to manifest again since I have equal standing with others among “inclusive” institutions. There are no thumbs on the scale.

In fact, sound institutions indeed have consequences – from the micro, to the macro, to the meta.

The confounding and maddening thing is, is that human nature being what it is, people like to have an edge; impartiality is great for the other guy. Throughout much of history, this human default setting has generally obtained, as societies have often evolved to support elites – the ones on top and benefitting nicely thank you, and the ones able to set rules and manage compliance.

In MMD’s geopolitical risk exercise, we have developed a qualitative scale or “composite score” that measures whether or not the current environment is resilient and stable. The score offers a measure of the geopolitical environment – an environment largely populated by sovereign states – based on evidence for international reciprocity, confidence in the international system, deterrence, and transparency.

High marks across these different facets of the international system or geopolitical environment mean a stable one; faltering of all or any of the facets can imply instability. For the global risk taker, this can imply poor institutional quality “at the local level”, so to speak, and an added premium layer of risk, as inconstant or feckless behavior by and among sovereign states gives rise to negative consequences.

A shakier geopolitical environment is yet another source of events that come “out of left field” to shock market participants. Being aware of the state of the geopolitical environment can help the global risk taker determine how he or she should hedge and how much powder to keep dry.

Robust, resilient states with inclusive institutions will probably show behaviors conducive, in the aggregate, to high marks among the “facets” noted above for the geopolitical environment. Sound institutions, leading to sound states, can help yield a sound geopolitical environment. The converse, unfortunately, is also true.

But how to measure whether institutions are inclusive or not at the national level? MMD accesses the periodically compiled World Governance Indicators (WGI), updated by the World Bank. Through the underlying survey work conducted for their updating, the WGI scores measure resident perception of country conditions related to rule of law, control of corruption, civic order and stability and other aspects of country institutions influencing economic, political, legal and social behavior. Toward developing a due diligence tool, we fitted and update a logit regression model that measures the association between country WGI scores and country default status. The association is a significant one, and offers effective guidance. An additional model derived from the logit exercise helps us also determine the tenor or maturity guideline for “clean” or non-collateralized exposure in a specific “country of risk”. This is a start, and these can be useful exercises in due-diligence in a risk intensive world.

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