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2007/2008 US financial crisis

This video uses the US financial crisis of 2007/2008 to explain the complexity and uncertainty principles in economics
Let’s look at the specific example of a complex system where there is a lot of uncertainty about its behaviour, but also some patterns. This system is the United States economy before the 2008 crisis. More specifically, we look at the United States housing markets, households and banks. They are all part of one system, the United States economy. In the 1990’s and 2000’s, the United States economy had stable growth, low unemployment and low inflation. And it had had this for 10 years, the longest period of uninterrupted growth in its postwar history. Most politicians and academics, therefore, regarded the United States economy as very stable.
And then in 2008, suddenly the financial system crashed, starting with the bankruptcy of Lehman Brothers, a large bank. And this financial crisis was followed by an economic crisis, and the longest and most serious postwar recession. This is typical of complex systems. Sudden changes and small beginnings, which can have large consequences. So in fact, looking back, the US economy was not stable at all. It was very fragile already in the growth period. The possibility of crisis was there. But apparently, that was not obvious to most. That is, looking back we know that there should have been large uncertainty about the possibility of crisis. But the strange thing is, most economists were not uncertain at all.
They were confident that there would not be a crisis. Now, was there any way that anyone could have anticipated a crisis? In a complex and uncertain world, can we make predictions, or at least can we confidently form expectations? Yes, we can, if we analyse the patterns that exist also in complex systems. They give us a guide to possible outcomes, even if they do not allow us to make precise predictions. Here are the patterns that characterised the US states’ economy. Its growth was mainly growth in consumption by households. In a sense, it was strange that households could continue to increase their consumption and thereby help the economy to grow, because household incomes in the United States were not growing.
On average, they’ve been flat for decades, since the 1970’s. But households were paying for their consumption in another way than from their salaries, by borrowing money from banks. They took out mortgages on their houses and spent the money. Because house prices were rising all the time in the 1990’s and 2000’s, until 2006, households could increase their mortgages continually and increase their spending on consumption and grow the United States economy. That’s it. It’s not complicated, is it? Quite simple. There are four steps in this reasoning. Increasing house prices leads to borrowing from banks, which leads to more consumption, and that leads to more economic growth. That was the regularity in the US economic system in the 1990’s and 2000’s.
But simple patterns often have large implications. We can now note two things which are certain. The first thing is that house prices will stop increasing at some point. And the second thing is that when this happens, economic growth will go down. If you know the numbers, you could quite simply calculate by how much. Now the few people in the United States who did this before 2006 recognised that this had to happen and that this would mean not just lower growth, but recession and high unemployment, somewhere before 2010. That’s how dependent the economy had become on rising house prices and continuing borrowing. Now at the time when they started saying this in the late 1990’s, almost no one took this seriously.
The US economy was extremely stable, after all. And indeed, it was. But it was also extremely fragile. If you saw the patterns, you could see that the fragility was increasing all the time. The possibility of crisis was increasing all the time. If nothing was done, one thing was certain in this uncertain world, crisis. And that’s what happens in 2008 and the years that followed. No one could have predicted which bank would be the first to go under or on what day that would happen. But anyone realising that we live in a complex and uncertain economy could have recognised the increasing fragility. So here we have a case study of doing science in a complex and uncertain world.
Identify the patterns, the causes and the consequences in the system. And this will then help you to understand if it is a stable system or an unstable system, if fragility is growing or decreasing. Crisis can be understood and anticipated, even if we cannot precisely predict it.
This video uses the US financial crisis of 2007/2008 to explain the complexity and uncertainty principles in economics.
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Decision Making in a Complex and Uncertain World

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