Forecasting Economic Crises

A screen at the New York Stock Exchange shows a lot of red, indicating widespread stock market losses, in New York on June 16, 2022. AP Photo/Seth Wenig

Commentary

Why have economic crises ‘sneaked up’ on us humans for so long?

Sure, there have always been lonely voices warning about an approaching collapse, but they have usually been met with laughter and ridicule. Nothing is naturally more rewarding for a forecaster than earning the ability to say “I told you so” without ever needing to speak or write those words aloud. I am closing in on that point now.

We, GnS Economics, have been in the forecasting business since 2012. First, it was more of a hobby, where we tested how the models and theories we developed in academia worked in “real life.” Everything changed after I started to feel uneasy on the path of the world economy in late 2016. Something felt wrong, but I couldn’t put my finger on it.

During New Year’s holiday my ex-wife, who was reading Daniel Kahneman’s Thinking, Fast and Slow which deals, e.g., with biases in forecasting, said to me why won’t you “just throw your forecasts out of the window and start anew.” That I did, and what I found was rather disturbing.

Growth of Global Economy

In the March 2017 report, the Bellwethers of a Fall, we wrote:

“The crisis of 2007–2008 reversed the trend of financial globalization, which has undermined global growth. The pull-back in financial globalization has been masked by central bank-induced liquidity and continuous stimulus from governments which have created an artificial recovery and pushed different asset valuations to unsustainable levels. This implies that we live in a ‘central bankers’ bubble’.”

It was a true moment of epiphany. The whole ‘growth model’ of the global economy had become dependent on continuous government and central bank stimulus. We pondered how long could this continue? The answer was, quite long.

When we analyzed the possible future paths, or scenarios, of the economy, we also, somewhat inadvertently, developed a rigorous method for economic and crisis forecasting. We did not recognize it at first, but we started to understand that we had developed a system of forecasting, which was able to account for all shocks hitting the economy. Basically, no action or development has come as a surprise to us since 2017.

We warned the subscribers of our Deprcon Service (the service was only available in Finnish back then) about the likely crash in the U.S. stock markets on Jan. 29, 2018, and published a blog warning on the same thing on Feb. 2 of that same year. Several days later, on Monday, Feb. 5, the Dow Jones Industrial Average fell by 1175 points, or 4.6 percent, its biggest point-wise daily fall ever before.

In June 2018, we warned that asset markets are likely to reach an ‘inflection point’ in September/October due to the withdrawal of both central bank stimulus (QT) and de-leveraging efforts of China. The asset market rout began in October and ended in January 2019 with the ‘pivot’ of the Federal Reserve.

In the December 2018 Q-Review forecasting report, we warned that the Eurozone would be likely to fall into recession in Q4 and the United States in Q1 2020. We reiterated our warnings in March 2019. The Eurozone fell into recession in Q4 2019 and the United States, helped quite notably by the Coronavirus, in February 2020.

We warned our subscribers that the Coronavirus outbreak in China is likely to go global (cause a global pandemic) on Jan. 29, 2020, and published a blog detailing the same on the next day. On Feb. 23, 2020, we warned that there is a risk of a heavily increased volatility in the asset markets. On March 8, we warned on the possibility of an outright collapse of the asset markets, and on March 11 on the risk of a capital market meltdown. On March 19, 2020, we noted that the crash is likely to be over, for now.

Fierce Asset Market Rallies

No one is naturally correct all the time, and we failed to see that we would see one of the fiercest asset market rallies in 2020 and 2021. In mid-March 2020, we only stated that we are in a ‘bear market', “which will also include energetic rallies, some of which may last for months”. We also expected the onset of a European banking crisis during 2020 and 2021, which failed to materialize (for now).

In March 2021 we warned about the approaching inflation shock and in June 2021 that the shock will last (be “persistent”). On Feb. 12, 2022, we warned customers of our Deprcon Service on the increased likelihood of a war between Russia and Ukraine.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City on July 21, 2022. Brendan McDermid/Reuters

How have we accomplished this, very successful forecasting record?

We use the combination of narrative and modeling to construct scenarios of possible future developments and to assign probabilities on them.

The narrative needs to uncover the imbalances, risks, and other vulnerabilities lurking in the economy and the financial markets. It is used to explain the process (to tell the “story”) of how an economic crisis or any major economic development comes to be. The narrative is crucial because the economy is a ‘living organism’, meaning that it evolves constantly, and without the narrative, which tracks its development, it’s basically impossible to reliably forecast the development of the economy.

For a reliable narrative, one needs to uncover the trends that will define the future path of the economy. They may be visible, like the very fast growth of exotic new financial products, called Collateralized Debt Obligations (CDOs) tied to the U.S. housing market before the crash of 2008, or more subtle, like slowly increasing non-performing (bad) loans in the balance sheets of banks.

While one can construct a reliable forecast on the approaching crisis from the narrative alone, it often does not provide an accurate estimate on when the crisis will arrive. For successful forecasts on timing, one needs statistical information either in the form of an actual statistical model or in the form of reliable economic and financial indicators. These naturally include several sources of possible bias, which I have detailed in some of my columns.

So, essentially, what you need for reliable economic (crisis) forecasting is an objective narrative and a reliable statistical model and/or statistical data. The trick is, how to find them and how to fit them together. You can find more information on this and on the method in a recently published Special Issue of our Q-Review series.

In the report, we also present our updated forecasts on the future path of the world economy, which are extremely dire. Basically, all major issues imaginable (economic depression, crisis, shortages, famine) seem to be coming to a head at the same time.

I honestly have never been this worried about anything before. I will dwell on this in more detail later.