Are we heading for a second global financial crisis?

Yes we are, according to John Kay, Oxford economics professor, FT journalist for 17 years and government advisor where he led the Kay Review in 2012 on equity markets.

He takes the view that the financial world has not yet learnt the lessons from the 2007/8 global crisis and is still in denial. He claims that the Value At Risk model, discredited by some, is still being used to make high-risk investments and that senior economists in the major banks still believe in their models.

These senior economists comfort themselves by saying that the global financial crisis was an extreme event within the model, whereas Kay argues that it was outside the model and points to its limitations.

Kay has been criticised for being stronger on diagnosis than solutions. However, he does point out the benefits of moving towards smaller banks, towards longer-term investment decisions rather than quarterly earnings, and with improvements in how we regulate financial markets.

But perhaps his most interesting analysis is that economists need to change their culture and become open to learning from other disciplines. The example he gives is how the legal profession deal with probability – they require a convincing narrative as well as itemised facts.

In his book, The Art of Thinking Clearly, Rolf Dobelli (2013, p204) reports on a study by two researchers, Hirschleifer and Shumway on 26 stock exchanges between 1982 and 1997.

“They found a correlation that reads much like a farmer’s adage: if the sun is shining in the morning, the stock exchange will rise during the day. Not always, but often.”

It is good to remember that there are limits to the uses of a spreadsheet econometric model and that ‘animal spirits’ still need to be factored in and controlled.

Links:
http://www.theactuary.com/features/2013/04/the-mild-mannered-prophet-of-doom/
The Art of Thinking Clearly, Rolf Dobelli, translated from German by Nicky Griffin. 2013. London: Hodder & Stoughton, Spectre.

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