Could Anyone Have Predicted the Financial Crisis?

     This a question that never goes out of style, the conventional wisdom is that it never could have been,  one notable financial authority who espouses this view is the Maestro himself, Alan Greenspan who admitted to being very surprised during testimony before Congress in 2008.

      On March 14, 2008, Robert Rubin spoke at a session at the Brookings Institution in Washington,

stating that "few, if any people anticipated the sort of meltdown that we are seeing in the credit

markets at present”. Rubin is a former US Treasury Secretary, member of the top management team

at Citigroup bank and one of the top Democratic Party policy advisers. On 9 December of that year

Glenn Stevens, Governor of the Reserve Bank of Australia commented on the “international

financial turmoil through which we have lived over the past almost year and a half, and the intensity

of the events since mid September this year”. He went on to assert: “I do not know anyone who

predicted this course of events. This should give us cause to reflect on how hard a job it is to make

genuinely useful forecasts. What we have seen is truly a ‘tail’ outcome – the kind of outcome that

the routine forecasting process never predicts. But it has occurred, it has implications, and so we

must reflect on it” (RBA 2008). And in an April 9, 2009 lecture Nout Wellink - chairman of the

Basel Committee that formulates banking stability rules and president of the Dutch branch of the

European Central Bank - told his audience that “[n]o one foresaw the volume of the current

avalanche”.

     These are three examples of the idea that ‘no one saw this coming’.

 
      http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf

     The above quote was taken from a paper written by Dirk J. Bezemer in June, 2009. With so many financial authorities insisting that no one saw it coming, Bezemer does a good hob of showing that this is not true. Among those who didn't see it coming the following familiar names did call it.

     Dean Baker, for example, in 2006 said, "plunging housing investment will likely push the economy into recession."

     Nouriel Roubini, AKA "Dr. Doom", in  2005“Real home prices are likely to fall at least 30% over the next 3

years“, and in 2006:  “By itself this house price slump is enough to trigger a US recession.”

     Peter Schiff predicted that in 2006 that "the United States is like the Titanic... I see a real economic crisis coming for the United States."

    I mention these to start with as they are well known but there are some others, who I at least was less conversant with who had some pretty inclusive  aniticipatory analyses.

    Kurt Richebacher, a private consultant and investment newsletter writer said “The new housing bubble – together with the bond and stock bubbles – will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession” (2001). “A recession and bear market in asset prices are inevitable for the U.S. economy… All remaining questionspertain solely to speed, depth and duration of the economy’s downturn.”(2006)

   For a sheer uncanny ability to make predictions that nail it on the nose, see the investor and iTulip commentator, Eric Janszen, who declared “The US will enter a recession within years” (2006). “US stock markets are likely to begin in 2008 to experience a “Debt Deflation Bear Market” (2007)

   In November 1998, Hanzen started the iTulip website to parody the then rampant "Internet Bubble" as a speculative manian. After calling the top of the dotcom bubble in March 2000 he shut the website down but started it again as the housing market developed into what he believed to be a bubble. In August 2001, Hanszen “expected that after the technology bubble crash the Federal Reserve and government was certain via tax cuts, rate cuts, and stealth dollar devaluation to induce a reflation boom like the 1934 – 1937 reflation created after the 1929 stock market bubble bust. Like that reflation, the stock market after 2001 was unlikely to produce meaningful inflation-adjusted results."

     Bezemer selected his list of accurate prognosticators carefully and rigorously. He studiously avoids the "stopped-clock syndrome" where as a "stopped clock is correct twice a day, and the mere existence of predictions is not informative on the theoretical validity of such predictions since, in financial market parlance, ‘every bear has his day’.ex post credibility,ex post correct but also rest on a 

    Elementary statistical reasoning suggests that given a large number of commentators with varying

views on some topic, it will be possible to find any prediction on that topic, at any point in time. With a large number of bloggers and pundits continuously making random guesses, erroneous predictions will be made and quickly assigned to oblivion, while correct guesses will be magnified and repeated after the fact. This in itself is no indication of their validity, but only of confirmation bias.

    In distinguishing the lucky shots from insightful predictions, the randomness of guesses is a

feature to be exploited. Random guesses are supported by all sorts of reasoning (if at all), and will

have little theory in common. Conversely, for a set of correct predictions to attain

it is additionally required that they are supported by a common theoretical framework. This study,

then, looks to identify a set of predictions which are not only

common theoretical understanding. This will help identify the elements of a valid analytical approach to financial stability, and get into focus the contrast with conventional models. In collecting these cases in an extensive search of the relevant literature, four selection criteria were applied. Only analysts were included who provide some account on how they arrived at their conclusions. Second, the analysts included went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links. Third, the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others. Finally, the prediction had to have some timing attached to it."

     What is really interesting is Bezemer develops this premise that the reason why these economists were able to foresee the real estate bubble popping but Greenspan, et al. held to the idea that there could be some deflation of the real estate market, but if so it would certainly be contained (Greenspan's premise was that as there is no national real estate market as such there could be no national real estate implosion, a premise certainly disproved empircally since). Bezemer's suggestion is that this is because of the limits of the dominant economic model of most economic policy makers: the equilibrium model of economic analysis. Bezemer suggests an alternative "accounting model" for analysis.

    To differentiate between the two, "A foundational issue, from which more specific differences follow, is the organizing principle of market equilibrium induced by firms and households acting as rationally optimizing 

economic agents. In contrast to this feature of models used for official forecasts, flow-of-fund models have an emphasis on accounting identities, on the role of uncertainty, of economic psychology and on political economy as the key behavioural assumptions."

    What rational equilibrium lacks is the Keynesian notion of ‘radical uncertainty’ as opposed to calculable certainty. Equilibrium only focuses on the productive activities of the real economy in its models and so avoids any question of the effects of the credit markets and the financial sector on the macro economy.

    The problem in the rational expectations model is that it only examines economic activity at the mircro level. While there is truth in the idea of individuals pursing their interests only analyzing at this level gives you no chance to analyze the economy at the level of the overall system. Essentially as most policy makers understood the economy only at this level there was never any chance that they could have anticipated the popping of the real estate bubble.

     For more on this fascinating discussion of an equilibrium model vs. an accounting "flow of credits" model see the work of Wynne Godley's "Money and Credit: An Integrated Approach to Credit, Money, Income and Wealth" and "Introduction to Post_Keynesian Economics" by M. Lavoie.