An inconvenient truth: crises are inevitable

First published in the Telegraph on 1 October 2009

The story will be instantly familiar to anyone who has read The Hitchhiker’s Guide to the Galaxy: some of the world’s most intelligent beings decide they want to know the answer to the Ultimate Question; they spend years creating an impossibly powerful computerised system to find it; eventually, the computer is switched on, whirrs into action and spews out its answer, which is… well, you probably know the rest.

This time, though, the Ultimate Question isn’t Life, the Universe and Everything, but rather How to Prevent Financial Crises. This time around, the supercomputer isn’t called Deep Thought, but Early Warning System.

Here in Istanbul, at its annual meeting this weekend, the International Monetary Fund will unveil a blueprint which, it is hoped, will enable policymakers to avoid the repeat of a crisis as nightmarish as that of the past two years. It is eagerly awaited – particularly by those, including Gordon Brown, who demanded an answer to the Question two years ago. But I gather they will be just as disappointed and perplexed as those who pinned their hopes on Deep Thought.

At first glance, there is some merit to the idea of an early warning system for the world’s financial system and economy. After all, markets failed to anticipate the crisis. Had you looked at the credit default swap markets, which were supposed to set out, in monetary terms, the risks facing the banking system, you would have been left with the impression that there were few better bets than the big banks. As we now know, they were catastrophically wrong.

Nor did the regulators do any better. But, tantalisingly, there were some who got close to predicting the chaos into which we have descended. Some British economists, newspaper pundits and even politicians warned about the fact that the housing market was looking dangerously precarious in the years leading up to 2007. Some (the Bank of England included) even said that banks stood to lose a hell of a lot of money because of their propensity to lend out sums they didn’t have in their vaults. Plenty – apart, it seems, from the Treasury – were worried about the record levels of debt racked up by British households. Many warned of a virulent recession.

Yet no one managed to put all of this together and identify the precise chain of events that triggered it all. No one anticipated the collapse of Lehman Brothers – or, for that matter, that of the entire global financial system. Which is where the conception of an early warning system comes in: when the crisis erupted two years ago, Mr Brown and others argued that the International Monetary Fund should devise a way to amass all these warnings, sound the alarm at the appropriate moment, and work out precisely how governments should tackle the danger.

The problem is that the task has proved impossible. The system the IMF will introduce to the public on Sunday (actually they are calling it an Early Warning Exercise) is a far cry from the all-seeing eye envisaged by Mr Brown. It will not make predictions about forthcoming crises, but will merely – and privately – pinpoint certain “tail risks” to governments – potential ticking time bombs in their financial systems.

You might say that this is simply an extension of what the IMF has been doing for years; and you’d be right. In the run-up to the crisis, the IMF issued countless warnings about the imbalances and vulnerabilities that threatened to overwhelm the world economy. It told Mr Brown that his over-borrowing was leaving the UK particularly exposed to a future recession.

Admittedly, the analysis could have been delivered at a higher pitch; but the problem was less that than the fact that the warning was ignored – not merely by Mr Brown and British policymakers, but by the men and women in the City, by those working in the mortgage trade, and by homeowners up and down the country, for whom the abstract threat of disaster had far less traction than the immediate threat of stepping off the property merry-go-round and losing money as a result.

As a new book, This Time is Different, by the economists Carmen Reinhart and Ken Rogoff, proves in devastating detail, humans have succumbed to financial crises for century after century, ever since the Middle Ages. They are a product of the fact that human life exists in a state of flux between rationality and emotion. This was something John Maynard Keynes understood, but that modern economists conveniently forgot.

It is an uncomfortable realisation, but there is no way of accurately determining a percentage probability of any one event happening. The biggest mistake made in the past decade was to believe we could predict the economic future. An early warning system, though it might prompt policy-makers to think twice about their actions, will not prevent the next crisis.

The more realistic option is to find better ways of mitigating the pain that follows a crash, of better understanding what went wrong, and of trying to pick up the pieces and get back to life as normal, as quickly as possible. Or, to put it another way, Don’t Panic.