First Factors that Might Spark a ‘Sudden’ Economic Recession Like That of 2008 or the Great Depression

The economy is a large complex system. A complex system by its nature is chaotic and unpredictable. People can see individual cracks in the financial system and economy, but it is hard to believe that anyone can understand all of its feedback loops until a crisis occurs.

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Nassim Taleb explains it this way:

. . . the world in which we live has an increasing number of feedback loops, causing events to be the cause of more events (say, people buy a book because other people bought it), thus generating snowballs and arbitrary and unpredictable planet-wide winner-take-all effects.

The factors that spark sudden economic crises like the Great Depression and the 2008 financial crisis tend to be systemic risks that amplify shocks. Correlation, connectedness, and contagion are three examples from Harvard Professor Hal Scott that can have these amplifying effects.

Their effects are often impossible to predict until after a shock occurs.

Highly correlated events and markets can cause financial panic. Markets are often uncorrelated until there is a crisis. Nonlinear feedback loops that no one new existed can suddenly become apparent as a result. This can lead to firesales that depress market prices below what people expected and amplify a shock.

Connectedness can lead to a domino effect and is often difficult to see in advance due to complexity and the limits to human comprehension. Many markets and financial institutions are connected in ways that are too complicated to understand. The collapse of the real estate market in Thailand can have unseen interconnections that hit Wall Street banks in New York—or they could not. Its hard to know in advance without an extremely comprehensive study. These interconnections can crash a system or be innocuous during a crisis.

Contagion in financial markets can be as dangerous and unpredictable as wildfire. It is impossible to know with high accuracy when people will start to lose faith in markets and start to panic. This can be the basis for a bank-run or a stock market crash. By its nature, contagion spreads in unpredictable ways and amplifies shocks to a system.

I feel obligated to add that both in the case of the Great Depression and 2008 financial crisis there were many weaknesses that should have been caught. However, my point about the unpredictability of crises is not that we should do nothing. The point that should taken away is that there should be more of a focus on resilience and remedying structural weaknesses rather than trying to predict events that are near impossible to predict.

Crises are unpredictable by nature because they are the result of nonlinear feedback loops that are not obvious until a shock triggers them. Factors that amplify these shocks in the economy include correlation, connectedness, and contagion. There should be a focus on resilience and remedying structural weaknesses rather than trying to predict the unpredictable.

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