Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 17 September 2018

How to predict a crisis

I was sorting through some old papers over the weekend (don’t ask) and I found an article I wrote for the Financial Times on 19th October 1990, which is also the month we entered the European Exchange Rate Mechanism (ERM). The article, based on work I had done earlier with colleagues at the National Institute (final published version here), argues that we were entering at the wrong exchange rate. The final paragraph starts with
“The danger is that the government will attempt to defend the present exchange rate bands at all costs. As a result it may produce, or fail to prevent, a recession on the same scale as 1980-81.”

According the current data vintage, GDP was already falling at that point, yet interest rates were not reduced by enough to prevent a recession because of concerns about pressure on sterling. GDP continued to fall almost continuously until we were forced out of the ERM (Black Wednesday). Leaving the ERM allowed interest rates to be lower and produced a 10% depreciation in sterling, which helped ensure a strong recovery.

I’m sure I wasn’t alone in making this prediction, but we were in a minority and we did produce the best analysis. The Global Financial Crisis (GFC) was of course a much bigger event, and far fewer saw it coming, so quite rightly 10 years later those economists who predicted something like it are getting media attention. They were very different events, so can we draw any parallels between them, or more generally is there anything that links disasters of this kind?

One common factor is using the markets as an excuse to avoid economic analysis. One of the two main excuses to ignore our ERM analysis was to look at the exchange rate at the time as say ‘the market must know what it is doing’.Of course before the crisis too many people who saw the data thought the banks must know what they are doing as they pumped up leverage.

Perhaps another is never let new ideas crowd out the knowledge embodied in older ideas. The other excuse that particularly academics used to disregard our analysis about the ERM entry rate was that the models we were using were a little old fashioned. (I talk more about that here.) Bankers fooled themselves that they had new methods of evaluating risk that meant they could ignore systemic risks. If we think of the other two major UK macroeconomic crises, the same applies. The Treasury predicted the recession of 1980 pretty well, but the analysis was trashed as the work of old fashioned Keynesians by Lawson et al from the Thatcher government. Austerity of course also ignored basic Keynesian truths.

One obvious final question is whether we learn from crises of this kind. Ten years after we left the ERM the Treasury asked me to do their entry rate analysis for possibly joining the Euro, so that at least implies some learning, but maybe being a different government helped. Perhaps Black Wednesday created a general distrust of fixed exchange rate regimes in the UK that helped Gordon Brown argue against joining the Euro.

Have we learnt the lessons of the GFC? Some changes to the banking system have been made, but I think the general consensus is its is not enough, and there still seems to exist a large implicit public subsidy for the major banks. If for no other reason that is why you should take note of what those who predicted the GFC say. In terms of how you recover from a financial crisis we certainly had learnt some of the lessons of the 1930s, but not all. As I argue in my last post, we have hardly begun the process of creating a macroeconomic policy regime that can deal with a future recession, let alone a crisis.


  1. Emerging from under stones are those who suggest that the GFC was caused because the authorities were too hard on the financial institutions, who should have been given more support.

  2. "we have hardly begun the process of creating a macroeconomic policy regime that can deal with a future recession, let alone a crisis."

    We know how to deal with a liquidity crunch: print more money. We should use that lesson to fund universal basic income on central bank balance sheets.

    Central banks have unlimited currency swap lines these days, so if the UK needs dollars it gets them at away-from-market rates from the Fed. With no capacity limits. Markets are not involved in Fed currency swap lines.

  3. Where is Krugman, Schiller, and Stiglitz on the list of those who predicted the crisis?

  4. A system based on debt, is an obvious systemic risk. The city produces nothing but speculates in order to accumulate, it doesn't worry itself about risk it just tries to predict the upward and downward movements in order to profit from it.

    The real question is what purpose does it really serve?

    Market philosophy is really dead in the water, in the 21st century why do we believe today's circumstances fit in with 19th century, when we have no manufacturing base to talk of, we are no longer a global power, and Neo-Liberal politicians have totally lost all credibility.

    Unless of course we just accept our masters know best and be just satisfied with anything that keeps us above the level of destitution that the poor in the rest of the world suffer.

    1. And your better idea is ... ?

  5. What do you think of Michael-Burry style analysis for predicting a future crisis? I wrote a post here titled "How to Predict a Financial Crisis"

    1. Professor Mark Blyth explains to market analysts why economics is unpredictable and that mathematics is not relevant as tool to predict it.

  6. How to predict a crisis: read Taleb.

  7. "Leaving the ERM allowed interest rates to be lower and produced a 10% depreciation in sterling, which helped ensure a strong recovery."

    But the Treasury predicted that in the aftermath of a Leave vote, sterling would fall, GDP would fall and employment would fall.

    There has not been a proper investigation as to why their predictions for the last two were so wrong, given that they were right about depreciation. It looks like they didn't understand the likely effects of a devaluation as described in the quote. Until they come clean, we will never know.

    1. So the Treasury's predictions are as accurate as a coin toss.
      Economics, innit?


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