Posted by: Nicholas Davis | March 29, 2009

Larry Summer’s 1989 depression scenario

Interesting – Robert Shiller has come out firmly in favour of the use of qualitative scenarios (which is what I do) to understand down-side risk in financial markets, and used work by Larry Summers as a leading example. Add two of the world’s best economists to the scenario planning fanboy list, please.

In an interesting piece in yesterday’s edition of the New York Times (It Pays to Understand the Mind-Set), he talks about hearing Larry outline a downside scenario very similar to the recent crisis at a conference in 1989:

Mr. Summers told a fictional but vivid story of a big financial crisis, complete with examples of specific events and how people might react to them. Seeing it concretized as an imaginary history, and placed in the near future — in just two years, in 1991 — made it seem more real and familiar.

Shiller argues that Summers was able to construct the scenario so accurately because it explicitly took human emotions into account. He concludes:

Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.

Naturally, I agree and would argue that having multiple, qualitative scenarios like Larry’s (that you accept won’t be reliable or accurate) is incredibly useful – both in understanding driving forces (such as the role of human emotion in markets), but also in accepting that the future is fundamentally uncertain.

I’d go even further than Shiller and say that a good start to managing uncertainty is  relinquishing the illusion of control that single, quantitative forecasts provide.

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