Friday, May 31, 2013

Noah Smith and what does it mean to have "predicted the crisis"

In an excellent post, Noah Smith asks the question of what does it mean to have "predicted the crisis" and then challenges anyone who claims to have "predicted the crisis" to examine their track record in light of his analysis.

Naturally, your humble blogger thought this would be an interesting exercise to apply to oneself because I frequently mention that I "predicted the crisis" and the success or failure of the different responses to the crisis.
Since 2008, quite a lot of people have boldly claimed that they "predicted the crisis". 
I confess to having made this claim.
Usually, the claimants use this "fact" to argue for the superiority of their economic school of thought, modeling approach, investing approach, or personal intuition.
I confess that I have in fact used not only my prediction of the crisis, but also the accuracy of my predictions of the success or failure of the various policy responses to the crisis to argue for my approach, the FDR Framework.
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 2007. 
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; many writers, such as Bill McBride, 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.
For the record, my predictions applied to the collapse of the global financial system and what it would take to avoid the deep recession and long stagnation that has occurred since the crisis began on August 9, 2007.
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.
My predictions fall into Mr. Smith's third and fourth category.

Caroline Salas and Bloomberg reported on December 4, 2007 that I was saying the solution for moderating the seizure of the credit markets driven by the toxic subprime mortgage bonds was to make them transparent so that market participants could accurately value them.

For example, Paul Kix and the Boston Magazine reported that I was saying in February 2008 that because of opacity in structured finance securities we faced a downward economic spiral until such time as transparency was brought to these securities.

Subsequently, but well before September 2008, I expanded the need for transparency to apply to all the opaque corners of the financial system, including banks.

After the financial crisis hit, my predictions, many of which are on this blog, then shifted to would a policy response or combination of policy responses policy makers and regulators were pursuing work or not work to end our ongoing financial crisis.

Just to remove any doubt about what policy responses I predicted would work, I have written extensively about the Swedish Model under which banks are required to recognize upfront their losses on the excess public and private debt in the financial system.
Next, there is the question of with what degree of confidence you make a prediction. Saying "this event is a conceivable possibility" is different than 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."
Regular readers of my blog know I don't BS when I make a prediction.  My predictions are all of the variety that "this event will happen."

For example, I predicted that BlackRock assessing individual banks would not restore confidence in the Irish, Greek or Spanish banking system.  In fact, it didn't.
Also, there is the question of how far in advance a prediction was made. That could be important.
Each of my predictions was made when there was still time for policy makers and regulators to listen to the prediction and choose a different policy response that would have been successful.
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.
Fortunately, my predictions were based on a model:  the FDR Framework.  The Swedish Model, which is the response to a bank solvency led financial crisis, is a component of the FDR Framework.

I confess, I hope the FDR Framework is not used as a model to predict future crisis events.  Rather, the FDR Framework is a model for how the financial system is suppose to work so that a future crisis can be avoided.

Simply put, what made our current crisis possible was the financial regulators allowed opacity into large corners of the financial system.  If we don't let this happen in the future, we shouldn't have another opacity driven financial crisis.
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.
When you look at which events I predicted, the degree of confidence of the prediction and the timing of the prediction, the FDR Framework stacks up incredibly well against any of the alternatives.

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