Nouriel Roubini predicted financial catastrophe with "holistic" analysis

Because modern society is extremely specialized, most of us live our professional lives within a tiny intellectual box. (Many of us also work inside a tiny physical box, a “cubicle.”) We write certain kinds of computer programs. We fix certain types of cars. We handle certain types of legal cases. We install certain brands of HVAC machines.

In many fields, such extreme specialization is efficient. You don’t need to know how to cook truffles if you run a school cafeteria.

But fields requiring prediction of human (business, social, governmental) behavior require broad thinking.

Sadly, the social sciences in American universities are specialized to an extreme. While earning my degrees in government and economics at top U.S. universities, I always felt constrained in both the methodologies I could employ and the geographies I could study. For example, it was doctrine that people act rationally. Deviations from rationality were considered random mistakes, trivialities to be ignored. Psychologists had uncovered many ways in which human brains are systematically biased and flawed, but the programs I studied in never allowed psychological models to form the basis of an economic or political science model. Similarly, studying the United States was strongly encouraged. Studying Europe was acceptable. Studying other countries was frowned upon. I wanted to study China, but, 15 years ago, few U.S. academics cared about China.

Another huge problem in modern academia is the glorification of mathematical models that ignore many real-world complexities. By focusing in on an important dimension of the problem, such “toy” models can be extremely revealing. But they almost never capture every important aspect of a problem. Consequently, excessive reliance on mathematical models can produce horrible results.

One immediate example: the models used by banks and ratings agencies that said aggregations of sub-prime and Alt-A mortgages were extremely safe. These models all built into them the assumption that housing prices would keep rising because U.S. house prices had never fallen year-over-year at a national level. But huge housing crashes had occurred elsewhere, like Hong Kong and Japan. And huge price crashes had hit particular American cities, like Houston. Excessive reliance on simple models and on data from the United States led to a massive underestimate of mortgage risk.

So I’m fascinated with how those who predicted this crisis did so. Nouriel Roubini says he anticipated the crisis through knowledge of Asian and Latin American monetary crises and “holistic” analysis:

While following the Asian and Latin American monetary crises in the late 1990s, he saw similarities be­tween developing countries and the U.S., arguing that they all fostered crony capitalists and tended to run huge current-account deficits. (In other words, they spent more money than they were taking in. In the case of the U.S., it’s like we were using an in-store credit card at a retailer named China.) He became convinced that the U.S. had the potential to be the biggest bubble of all, and by 2004, he was speaking and writing about his belief that the country was facing economic catastrophe.

Roubini calls his economic approach “holistic.” Instead of primarily studying mathematical models and formulas, he says he also draws his ideas from history, literature, and international politics. He maintains that this eclectic approach is what helped him be so prescient…

The article that arguably made his career, “The Rising Risk of a Systemic Financial Meltdown: The 12 Steps to Financial Disaster,” was posted on February 5, 2008. It pegged the start of the recession to December 2007 (dead accurate, it turned out) and warned that the downturn would be extremely severe, thanks to the continuing housing bust and the bursting of the credit bubble, which would, in turn, lead to an intense credit contraction and a “serious and protracted” falloff in consumer spending. For good measure, he also predicted the failure of at least one bank with heavy exposure to mortgages and major problems in the shadow banking system, which would affect everything from hedge and money-market funds to investment banks and structured investment vehicles. Losses on credit default swaps, he predicted, could lead to the bankruptcy of a “large broker dealer,” and the entire chain of sorry events would cause an inevitable downward spiral. Bear Stearns collapsed a little more than a month later.

Posted by James on Saturday, April 04, 2009