Robert Engle: Hello. Today, we’re going to talk about long run risks and global financial volatility. We’re going to put all the pieces together that we’ve been discussing for the last week. In a recent study that I did with Gonzalo Rangel, which is a study of long run risks, we calculated the volatility for each of 50 countries, over a 13-year period, and then we tried to figure out what made one country more risky or more volatile than another and what made one time period more volatile or less volatile than another.

The results are a little bit complicated to look at. You can see, on the right hand side of the slide, there is a bar graph which describes the average level of volatility in all these countries over the time period, and you can see that it ranges from 15 per cent down to maybe 12 per cent in the middle ‘90s, rising up in 2000, and then falling at the end of the sample, just like it did in the US, although the timing’s a little bit different. This is an effect which you can see in all financial markets around the world. This is a common volatility effect that all these countries see. We see countries with larger market capitalisation, that is, they have bigger stock markets, have less volatility. Countries which have more listed companies have less volatility. So when the financial markets are more developed, the volatility is on average a little bit lower.

We also see that the faster the GNP is growing in our economy, the lower its volatility, and correspondingly, of course, when the GNP is declining, which would be the case when a country is in a recession, you’d expect to see higher volatility. Another major cause of high volatility is inflation. When you see high inflation rates, you tend to see high volatility. When the short term interest rates fluctuate a lot, or when the economy fluctuates, either in real output or in inflation rates, then this macroeconomic volatility contributes to financial market volatility. It’s not a very surprising finding, but it’s reassuring that stability in the macro economy corresponds to stability in the financial markets.

And this is a lesson for policy makers. If you want your financial markets to be more or less stable, it makes sense to try to regulate very effectively your macro economy, not moving interest rates too fast one direction or another, not stopping and starting your fiscal policy. You keep the growth even and steady.

So, this is a way of describing long run risks in the macro economy, but there are some other risks that maybe we should call very long run risks. These very long run risks are also important in describing why financial markets are volatile and why we think that the long run outcome may be more volatile than what we see today.

The two I would like to focus on are climate change and under-funded public pensions. These two problems are closely related because just when the pay-as- you-go system means that the workers won’t have enough, will be taxed very heavily to support their retirees, the global economy is likely to need repairs. We’re going to need to do something about the climate. We’re going to have perhaps to do drastic measures at that time. Both of these outcomes are going to require heavy taxes and this is a concern that we all, I think, feel today and we expect to feel increasingly in the future. So, this is what we mean by a long run risk.

So, let me propose a solution. My solution is a solution in part which almost all economists would agree to. The best solution for solving the climate change problem is to put a comprehensive tax on the emission of greenhouse gases, such as carbon dioxide. If you have a comprehensive tax, then people who are able to avoid it are doing exactly what you want them to, and you don’t have to subsidise alternative methods of producing energy because they will already have a benefit from not being taxed. So, a comprehensive tax is an ideal solution from an economic point of view, but it’s thought to be politically impossible.

So, my suggestion is that we tie these two problems together. We take the tax revenue from a carbon tax and apply it to a fund that would invest in financial markets for eventual use in supporting the retirement system. With one policy, you reduce both risks. You offset them against each other.

Well, this is just a little schematic, but it suggests how solving long run risks today can provide benefits today, even though the risks weren’t expected for many, many years.

In the next picture, you see some people that you might not at first recognise. What this is, is a picture of Microsoft employees in 1978. That’s about 30 years ago, and you see in the corner Bill Gates, who is currently the richest man in the world, and you can think about what happened to Microsoft in those 30 years. It has grown from a small, start-up company to an enormous, powerful corporation. Thirty years goes by very fast, and if we do something about global warming today, in 30 years we could have an effect as big as the effect of Microsoft.

So, in summary, I’d like to close today by suggesting that we all keep an eye on long run risks as well as short run risks, that we consider solving long run risks because that will have benefits today and that we take only the risks we intend to take.

Thanks for joining us this week. I’ve enjoyed talking with you about global financial volatility. You’ve learned, I hope, about how to measure volatility, what its causes are, and what some of its consequences are for portfolio selection, measuring risk. I hope this will help you better understand current events and plan for the future, because we have many long run risks to worry about over the next few decades. Thank you.