What it means to predict a crisis

by on September 21, 2009 at 7:44 am in Economics | Permalink

Some economists are trying to get macroeconomics off the hook by arguing that by their very nature crises are unpredictable.  Thus David Levine aggressively argues that "our models don't just fail to predict the timing of financial crises – they say that we cannot."

There are three problems with this argument.  First, it assumes what is it at question – namely whether what Levine calls "our models" are good models.  Perhaps behavioral models could better predict the timing of financial crises.  I will not push this argument but I do believe that current events call for a greater than normal willingness to think beyond the confines of the models that one defends.

Second, it's not true that "our models" tell us that we can never predict a financial crisis.  In some cases, our models predict the exact moment that a crisis will occur and these models are perfectly consistent with, indeed require, rational expectations.  It is perhaps no accident that Paul Krugman has specialized in these types of models.

Third, the word timing is misleading.  Let's accept that a crisis cannot be predicted to the day or even to the year.  Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis. 

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur.  If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten.  Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis.  Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.

All of this is true even in the context of stock markets.  Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms.  It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet.  It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense–even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models. 

1 babar September 21, 2009 at 8:26 am

> It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

easy to test whether the market believes this: look at the options markets

2 capitalistimperialistpig September 21, 2009 at 8:36 am

Your number 3 is the biggie. We can’t predict when excessive speed or drunken driving will cause a crash, but we do know that each makes crashes more probable. Predicting the timing of financial crises is beside the point, what we want to do is limit behavior that promotes or aggravates such crises.

3 michael webster September 21, 2009 at 8:56 am

On a different but related note, the models used to derive pricing for securitized mortgages made a spectacularly wrong prediction: that housing markets would remain local in nature and a downturn in one market would likely be offset by an upturn in another market.

So far, I haven’t seen any good explanation of how and why they got this wrong. (Bad explanations are along the line, we didn’t have enough data.)

4 JW September 21, 2009 at 9:11 am
5 audiokabel September 21, 2009 at 9:53 am

Very simple: economy it’s not an exact science, as mathematics, that is, with a primary formula you could preview the future and solve any economics fact.

6 Andrew September 21, 2009 at 10:30 am

HFS, I agree with capitalistimperialistpig.

7 steve from virginia September 21, 2009 at 11:38 am

Predictability (or its lack) is certainly the economic ‘flavor of the month’. It’s all over the blogs and even Krugman has gotten into the act.

It’s funny watching the macros trying to absolve themselves, when anyone who follows yields (and yield curves) could have predicted this crisis years ago.

For instance, Fannie Mae and Freddie Mac were of questionable solvency when house prices were on a tear in 2002 and 2003 and money costs were near 1%. Figuring the spreads on the back of a piece of scrap drywall, it would be clear that both – the GSE’s and the real estate industry that depended utterly upon them – would be kaput if the Fed Funds rate exceeded 4 percent.

It did and they did. Very predictable. In 2005, I was telling people that the real estate boom was over and for the highly leveraged to get out. Nobody listened to me and a lot of people I know are busted. This is why my brother introduces me as, “my brother who predicted the banking crisis five years before is started”.

George the Electrician predicted the financial crisis long before, as well. “It’s the American way,” he said, “to drive an idea into the ground then walk away from the wreckage and go somewhere else and start over.”

Neither Paul Krugman nor the rest of his macro compatriots got it. This crisis was a no- brainer. What’s also a no- brainer is that the current crisis will get worse. In the background are all the same ‘missed the boat’ economists calling for a (speedy) recovery. Wrong again. Yields are the indicator again as the banking system is flickering near death even when money costs are near zero. What happens when yields start to rise – an indirect result of the flood of liquidity pouring into the banking and finance sector?

Answer is a return to bankruptcy with a vengeance. If the system is degrading while cheap debt is raining down like manna, what does the establishment have as an alternative when the off- balance sheet bad loans start to emerge onto the market looking for a buyer, any buyer? The Fed and the Treasury have nothing new other than what they are already offering; cheap dollar loans.

The finance/loan bubble represents the percentage of bad loans the government can zombify. It can’t zombify all of them; the government has one foot in the real economy and the zombie process reduces the value of the dollar, which is also used to purchase the 10 million barrels of crude oil that are imported into America every single day.

The price and availablity of crude oil is the connecting factor whereby finance aims to swamp the productive economy. Not enough crude or too high a price in dollars and there is no economy, period! Right now, the price of oil is too high to support ANY productive growth; almost all that is being currently registered worldwide is central- bank- bloated price inflation of speculative assets such as stocks. This contrived ‘growth- lite’ is a failing hedge against the high price of the resource necessary for top line commercial solvency. The earnings are only for speculators, not for producers.

It’s as if a region hopes to profit by a gambling casino – where some neighbors take money from their neighbors – while all the factories and shops in the region close their doors. This is the ‘real paradox of thrift’: eventually, the lucky – or cheating – gamblers take their winnings home – to the Turks and Caicos. The rest are left destitute.

The productive economy lacks the physical means to service then retire all the debt that overhangs it. The outcome is deflation, but the mainstream modelers don’t recognize this. They also miss the energy problem, the debt overhang problem, the trapping of liquidity within finance problem, the inability to earn/service and retire debt problem … and will with certainty miss the next deleveraging leg.

It will comes as a great surprise to them and the ‘Black Swan’ will fly again. Good grief!

8 Josh September 21, 2009 at 12:06 pm

Yes the crisis was entirely predictable, except for the timing. So are the dozen other predictions of how the dozen other nesting bubbles are going to pop. The Russian Roulette example implies a bearish viewpoint which is that all predictable bad events are going to happen if we keep playing. It may even be true, but who was it who said that the market can stay irrational longer than you can stay solvent betting against it? The timing and time scale is very important, and it doesn’t even take an economist to see many of the looming potential disasters.

But in the meantime, there’s bonuses to be made and elections to be won.

9 Thomas DeMeo September 21, 2009 at 12:50 pm

So macro cannot dependably warn society of an impending crisis. What can it do?

10 DanC September 21, 2009 at 1:55 pm

I am glad that Steve from Virginia, clearly a multimillionaire because of his ability to predict obvious market errors, has taken time away from his world tour to tell us how we can become millionaires like him.

Or did you lack the courage of your convictions to actually bet your retirement money on what was so very obvious?

11 DanC September 21, 2009 at 2:03 pm

Also Steve from Virginia, read the John Thacker post. If you saw the problem five years ago, and had bet against the market five years ago, unless you have very deep pockets, you would have gone broke before your bet would have paid off. Some others went broke thinking the market should have turned sooner.

Saying that the crow can only fly so high doesn’t tell you when he will peak and descend.

12 eccdogg September 21, 2009 at 2:46 pm

This whole “The market can stay irrational longer than you can stay solvent” line is pretty much BS. That is only true if you use leverage. There are lots of non leveraged ways to bet against the market.

First and easiest is get out of stocks if you are in them. You can hold that position forever.

Second if you want to go further short sell S&P 500 futures against the cash you have in the bank making sure that you allow for a considerable cushion for margin calls. For instance make sure that you have enough cash to cover margin calls over ten years equal to the greatest 10 years ever times 2. Unless the market grows at twice the amount it has ever grown over the next ten years you can hold your position for at least 10-years before your capital is exhausted.

You can also buy one year ATM puts with 10%
of your capital each year for ten years.

Both of these strategies allow you to ride out any irrationality for at least 10 years while betting on a drop.

So if folks “absolutely knew we were in a bubble” and it was “clearly evident” their are plenty of strategies to bet that way with a ten year time horizon.

Also you could have sold your house and rented locking in a long term lease.

13 Andrew September 21, 2009 at 3:26 pm

I meant Ken Fisher, the son.

14 Chris D September 21, 2009 at 3:46 pm

Predicting when a crisis will happen would be useful, but more worrying were the constant claims, from Greenspan and Bernanke and onward out to so many economists, that there simply was no problem. That the stock market was fine, the housing market was fine, despite ubiquitous, obvious evidence to the contrary. Starting in 2005 I spent 20 minutes a day reading the news links from http://patrick.net, and from those it was readily apparent there was a housing bubble. (Janitors making $40,000/year, buying 2-bedroom houses for $600,000? Exactly how sophisticated does your model need to be to understand that the system was heavily broken?)

I’ll leave it to the economists to explore the details of everyone’s thinking process in their field, but from an outsider’s perspective, it looks like either (a) ordinary sheer incompetence, or (b) wilful blindness leading to sheer incompetence.

15 spencer September 21, 2009 at 4:16 pm

It is not that an individual, or a theory can predict a crises or collapse.

It also has to be able to convince a sufficient number of other people that they will change their behavior enough to change the outcome.

16 Nathan September 22, 2009 at 3:13 am

See David Colander’s testimony to Congress on this subject:
http://www.zerohedge.com/article/guest-post-it-models-or-economists-statement-david-colander

17 Shalom P. Hamou September 22, 2009 at 6:01 am

Well the truth is that the collapse of the system is inevitable.

I have proved that a market is in an unstable equilibrium when long-term interest rate don’t pay for the interest rate risk.

It is akin to an undervalued option.

It is the irrational exuberance.

The Greenspan Conundrum which is due to the explosive nature of income disparity shows that tis disequilibrium is inevitable.

A Crash occurs when there is random shock to the Market makes the yield curve return in a split second to its normal, stable equilibrium shape.

Because it is a chaotic behaviour it is theoretically impossible to predict.

However the more the yield curve is far from the stable equilibrium the higher the probability of a Crash.

Although the yield curve is already below its stable equilibrium I believe the chances of a Crash now is low. But that could change fast.

I expect that with a yield on te 30 Years US Treasury Bonds below 3.80% the chances of a Crash will increase significantly.

I propose you something to be for. Something you can really implement: Adjusted Credit Free, Free Market Economy.

It is more libertarian, fairer, more stable than the Capitalist system

Libertarians for the Adjusted Credit Free, Free Market Economy.

Market Crash Security Procedures to Avert a Man Made Disaster.

Register for The Post Crash Economy: Operation F**k the F*d!

18 Drewfus September 22, 2009 at 4:48 pm

There does not appear to be any understanding from the Greenspan and Bernanke types that credit growth cannot occur independantly of the economies capacity to produce.

If arbitary credit growth is an alien concept to the mainstream macroeconomist, then it is clear to me that macroeconomics is a science in name only.

19 tripods September 23, 2009 at 3:29 am

To predict crisis means predicting the end of the resources or to predict the full consumption.

Most economic models do not even acknowledge, much less incorporate, the role of human emotions. The official (state-supported) economic orthodoxy is Keynesian and it is based on the efficient market presumption. The recent past (and more to come in 2010) demonstrates that the laws of supply and demand do not apply to financial investments. Financial investments involve uncertainty, and humans default to follow the herd in situations of uncertainty.

There is a new science that does not only acknowledge the role of human emotions, but incorporates it into analysis and predictive models. Try SOCIONOMICS. (- not to be confused with social economics, which is just a tear-jerker version of Keynes.) SOCIONOMICS is founded on the basis that human emotion drives macroeconomic cycles.

There is nothing in Keynesian economics that acknowledges that the velocity of money can collapse as it has recently; Keynesians cannot explain it and they have NO TOOL to deal with it. They are throwing money at it, but it just continues to fall. SOCIONOMICS can explain it, and can explain how it cannot be immediately reversed. CANNOT.

20 John Quiggin September 23, 2009 at 1:39 pm

“First and easiest is get out of stocks if you are in them. You can hold that position forever.”

True, and I did. More generally, if you see an unsustainable bubble in asset prices, getting out of risky assets is a good idea, but but of course that doesn’t eliminate the bubble unless a lot of people do it.

The other strategies count on more detailed prediction of exactly what will crash. For example, I expected the housing crash to be preceded by a run on the $US, but going short against the $US would have been a very bad idea.

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