Can you predict the next economic crisis?

Money, News, Politics

It’s been eight years since the onset of the worst financial crisis in the United States since the Great Depression of the 1930s.

In the space of about a year and a half – from December 2007 to June 2009 – the U.S. economy saw an $8 trillion housing bubble burst and 8.4 million jobs evaporate (affecting 6.1% of all those employed), in what has come to be known as the Great Recession. That crisis, at least for a time, fractured American confidence in our economic system.

Sometime between 2014-2015, as jobs rebounded and the national economy stopped contracting, commentators and analysts declared this period of decline over. The January 2016 unemployment rate was 4.9 percent – its lowest in eight years – and the economy added an average of 222,000 jobs a month during 2015.

Yet once again, fears of a “looming financial crisis” are being sounded by some economists and financial analysts. Should you heed these warnings? Or is this just an indication that economic confidence still has a ways to go?

Recipe for crisis

There are some standard ingredients that need to be in play for a financial crisis to come together. First, enough time has to have elapsed since the previous crash that we collectively forget. Our short attention spans cause us to lose focus on much needed risk aversion.

Next comes a sustained period of growth, during which we become convinced that the current good times will never end. As economist Andrew W. Lo has stated, a long financial boom “breeds an atmosphere of risk tolerance and complacency” and “financial gain actually has some of the same effect on your brain as cocaine.”

Finally, there must also be an unquestioned belief in the competency of those in power – a trust that central banks, policymakers, and regulators are sufficiently knowledgeable and capable to prevent another economic calamity from occurring—and conduct their transactions in a non-fraudulent way.

Modern-day oracles

Listen long enough to the frequently contradictory predictions of economists and financial analysts, and these dueling experts begin to sound like the ancient soothsayers and fortunetellers, prognosticating about when the wind will change direction or the rain will come down.

Contradictory economic forecasts are a product of the complexity of today’s global economy. In this era of globalization, where goods and services flow across borders to distribute resources to most of the planet’s 7 billion human inhabitants, the global economy is the sum of all human economic activity. This perpetual activity is interconnected and unimaginably complex, making accurate prediction extremely difficult.

But even if experts cannot accurately predict a crash in time to change course, economic crises seem to happen with a noticeable regularity and frequency. According to Larry Elliott, economics editor of The Guardian, “a 15-year gap [between crises] is the norm.”

System Malfunction

The inevitability of economic crises seems undeniable: the 2007-2008 subprime mortgage crisis; the dot-com bubble of the early 2000s; the savings and loan crisis of the 1980s; the energy crisis of the 1970s; the Wall Street crash of 1929 and the ensuing Great Depression. And those are the major economic crisis. If we include all 47 recessions that have hit the United States since 1790, the list gets substantially longer.

But let’s focus on the big crises – the ones that are supposed to happen so infrequently that they are called hundred-year events. How is it that several of these once-in-a-century financial calamities have happened in just the last few decades? Why didn’t we see them coming?

Whether we wish to acknowledge it or not, we live in a world beset by seemingly unpredictable events – natural disasters, wars, and, of course, financial crisis. But there is a difference between extremely rare events, or “black swans,” and events that are still infrequent, but more likely than they first appear.

Swiss scientist and theoretician Didier Sornette has dubbed this latter category “dragon kings” kings because of their large size or impact; dragons because of their unique origins. In terms of economic crises, Sornette has stated they are “generated by specific mechanisms that may make them predictable, perhaps controllable.”

What are those mechanisms? According to Sornette, dragon kings occur because a positive feedback mechanism creates extraordinary growth – think of unbridled optimism that fueled the mortgage bubble. When the positive feedback loop collapses, a dragon king bursts forth. And, according to Sornette, they do so far more frequently than we thought. Hence, the hundred-year events that occur much more frequently than expected.

But Sornette’s theory goes beyond explanations of past crises. He argues that dragon kings can be predicted. “These processes provide clues that allow us to diagnose the maturation of a system towards a crisis,” he says.

Having been created in 2008 Sornette’s theory is still in its early stages, so nobody knows for sure whether it is a game changer or just wishful thinking.

Regardless, it’s advisable to diversify investments, make sure your house is in order, and plan for the worst while hoping, as they say, for the best.