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Skip to 0 minutes and 10 seconds Surely, always predicting the same thing about the economy is not a very helpful way to be an economist. So what is a helpful way to think about financial crisis and about economic instabilities? We cannot precisely forecast them, since we do not live in a deterministic world. I cannot tell you that on 24 February, 2019, the next financial crisis will hit, because then a bubble in land prices will collapse, say. We do not know what financial instruments will be invented next year. We do not know which markets will form a bubble, if there is going to be a bubble. We do not know why it will collapse and when that will happen. So are financial crises completely unpredictable? No.

Skip to 1 minute and 1 second Like so many things in nature and society, there are patterns which we can research and understand, even though there is no determinism. Here are some things which we do know for sure. We know that investments in financial markets and real estate are driven by people’s expectations. And we know that people, in the good times, have a tendency to form over optimistic expectations, so they will borrow too much and invest too much, because they will expect more and higher returns than can be possible. Well, that is just the definition of a bubble. So it follows, we know that capitalist economies always have the tendency to form financial bubbles.

Skip to 1 minute and 55 seconds And we know that this will not just be a tendency, but it will actually happen unless you actively stop it. So when markets are deregulated, that is, when this tendency to form bubbles is given free rein, then financial bubbles will form and bubbles will burst. And we know the telltale signs of a bubble. The growth of bank credits and other lending accelerates. Debt levels in households and firms rise. Asset prices start rising, exponentially rising in the end. And we know that such bubbles must burst, because exponential growth cannot continue forever. That’s why we call it a bubble in the first place. So in fact, we know quite a lot.

Skip to 2 minutes and 45 seconds We are able to identify that the economy is becoming financially fragile when that happens. We are able to see it when the possibility of a crisis is increasing all the time. So we can say something about the sustainability of our economy’s growth path. The key word is fragility. Fragility is not crisis. But fragility increases when the possibility of a crisis looms ever larger. We may be unable to predict a crisis, but we can observe increasing fragility. And then we know that a crisis must come, if we do nothing. Now that is quite something. In fact, it’s as good as physics or medicine, even though economics is a very different discipline.

Skip to 3 minutes and 41 seconds A doctor may know for sure that a patient will die of disease if he’s not treated, even if the doctor doesn’t know exactly when and in what way the patient will die. That’s not the important thing. The important thing is the diagnosis and the medicine. Likewise, a physicist may know for sure that a bridge will collapse if it’s not repaired, even if the physicist does not know at what day the collapse will occur or how much traffic precisely is needed to make that happen. That is not the important thing. The important thing is the diagnosis and the repair needed.

Skip to 4 minutes and 26 seconds Now in just the same way, economists can’t know that a house price boom, for instance, cannot go on forever and that economic growth will turn into recession if we let that house price bubble grow and burst. The economist may not know for how long the bubble will continue to grow or what precisely will be the trigger for it to burst, but that is not the important thing. The important thing is the diagnosis and the change in financial policies needed. So remember this word fragility. It’s not stability. It’s not crisis. But it is possibility of crisis, even while things are still stable. A very useful concept. For when you think of it, complex systems always have some degree of fragility.

Skip to 5 minutes and 24 seconds But how do we know when fragility is rising?

Patterns in a complex system

Even while determinism is not an accurate view of how the world works, this does not mean we are not able to make any statements about the future. This lecture explores the notion of being able to recognise patterns in complex systems even if you cannot completely predict them - and what role fragility plays.

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Decision Making in a Complex and Uncertain World

University of Groningen

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