Crisis Prediction

Since 2008, quite a lot of people have boldly claimed that they “predicted the crisis”. Usually, the claimants use this “fact”images to argue for the superiority of their economic school of thought, modeling approach, investing approach, or personal intuition. But what does it mean to have “predicted the crisis”?

First of all, there are different things that get labeled “the crisis”. These include:

1. The big drop in U.S. housing prices that started in 2006-7.

2. The systemic collapse of the U.S. financial industry that began in 2008.

3. The deep recession and the long stagnation that began in late 2008.

Predicting one of these is not the same as predicting the others. It is possible, for example, to have missed the housing bubble and the finance industry collapse, but to have successfully predicted, after seeing these events happen, that a deep recession and long stagnation would be the result; this is what Marco Del Negro et al. claim to have done, and a number of pundits and commentators made informal recession predictions after housing peaked in 2006. Alternatively, it is possible to have predicted the bursting of the housing bubble without foreseeing the systemic damage that this would cause to the financial system; some economists, such as Dean Baker and Nouriel Roubini, seem to have done this (and of course, Robert Shiller). It is also possible to have predicted the collapse of the big banks and their mortgage-backed bonds – and made money off of this – while staying agnostic about the macroeconomic consequences; this seems to have made a lot of money for investors like Steve Eisman and John Paulson. Of course, in theory it might have been possible to predict all three events.

Then there’s the question of what it means to “predict” something. Here are some alternative definitions:

1. You could predict the timing of an event, e.g. when the housing bubble would burst.

2. You could predict the size or severity of an event, e.g. how much house prices would decline or how much the economy would contract in 2009.

3. You could predict the duration of an event, e.g. how long our economy would stagnate after the recession, or how long it would be before housing prices reached their pre-crash peak.

4. You could describe the particular characteristics of an event, e.g. what would cause banks to fail, or whether they would be bailed out, or whether inflation would remain subdued after the recession.

Next, there is the question of with what degree of confidence you make a prediction. Saying “this event is a conceivable possibility” is different from saying “the risk of this event is high,” which is different from saying “the risk of this event has increased,” which is different from saying “this event will happen.”

Also, there is the question of how far in advance a prediction was made. That could be important.

Finally, there is the question of whether the prediction was made by a model or by a human. If it’s a model, then there’s the hope that humanity has a tool with which to predict future crisis events.

Anyway, how should we evaluate these claims? There are so many different combination of “predictions” and “crises” here that it’s very difficult to lay out an explicit taxonomy of who got it “more right,” and who got it “less right.” As a more humble goal, we can examine a specific individual or model, and identify which events he/she/it predicted, with what degree of confidence, and when.

Noahpinion did a study on it. and concluded  that predictions are hard, especially about the future. Sometimes people get things right because they understand how the world works, and sometimes they get things right by luck. The idea of a brilliant Cassandra-like sage, shouting in the wilderness while everyone ignores his or her trenchant warnings, is occasionally true, but not as much as we would like to think.

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