CRISIS/ A Possibility Made into a Certainty. Is There Another Possibility?

Everybody is talking (about the) crisis. Since it started, the ongoing economic and financial crisis has become the most discussed topic on TV, newspaper, magazine, blogs, etc. The more we talk about it, the more we get into it. The process can be described as a self-fulfilling prophecy: the definition of a situation - and the prediction for the future that follows- translate into actions that make the original conception come true. Examples of such prophecies are frequent in human history, from Romulus and Remus to Kung Fu Panda, with the legend of Oedipus probably being the best known example. Many other examples of a self-fulfilling prophecy mechanism can be found in the current crisis.

Consider how the crisis was triggered, with the failure of Lehman Brothers – same with Bear Stearns: rumors get spread that the bank is facing liquidity issues. Is this true? CEO says rumors are “absolutely not true” and the bank has “enough liquidity”. Unfortunately, shareholders do not believe him. Share price start to fall quickly. At the same time clients start pulling business from the bank. This in turn fuels rumors of the bank’s insolvency and upcoming bankruptcy, causing the shares to drop even further and more clients to pull business. But the bank relies on its stock while they leverage to obtain financing. As capital requirements become too much for the firm to handle, the bank becomes insolvent and has to declare bankruptcy. It is the bank run – another very well known example of self-fulfilling prophecy.

Consider the subsequent fall of consumers' confidence: economists start predicting a severe and prolonged recession. All kinds of economic data and evidence are out there, supporting their findings. It is the worst-case scenario. Are they right? Are they wrong? It does not matter. We all start (consciously or unconsciously) adjusting our expectations to this new worst-case scenario. Because we now have worst–case expectations (and experts recommend having six months' worth of living expenses to cover your family in the unfortunate event of a job loss or serious illness…) we adapt our spending behavior accordingly: we stop consuming and we start saving. Because everybody is doing so, and lower consumer spending -which accounts for 70 percent of the U.S. economy- translates into decreased earnings for companies, the entire US economy slows down. It is a self-fulfilling prophecy.

Consider Wall Street's reaction - investors, equity analysts or rating agencies. I am an analyst and a company brings me their projections for 2009. I now have to consider the worst-case scenario (because we are in an economic crisis, because all experts say it is going to be so bad…). To include this new risk, I change assumptions in my forecast and end up cutting by 50% the company’s projected numbers. I am now looking at some measures that are worth a smaller investment, a cheaper stock price, or a lower credit rating. All things that could lead to liquidity issues, which could lead to default... At the beginning of the day the company was doing fine….self-fulfilling prophecy.

Does this mean that a crisis did not exist from the beginning? No. I believe self-fulfilling prophecies do not necessarily starts with a false definition of the situation. Although the prophet will always cite the actual course of events as proof that he was right from the very beginning, I think a self-fulfilling prophecy has neither false nor true value. It is a statement. As every statement, it can be true or it can be false. Thus it represents a possibility, one possible outcome. However, the possible turns into probable as we let the prophecy become our expectations for the future (our forecast). Then probable turns into a certainty as we take decisions and actions based on those expectations.

The importance of expectations about the future in economic theory is not new - Keynes referred to them as “waves of optimism and pessimism” that helped determine the level of economic activity. The assumption of rational expectations used by many macroeconomic theories implies that people do not make systematic errors when predicting the future. Thus it assumes that outcomes do not differ systematically from what people expected them to be (the optimal forecast). Game theory further defines expectations with the additional assumption that each individual will behave in ways that maximize his own utility or profit. In zero-sum games like the prisoner dilemma assuming that another individual will act to get the maximum for himself translates in assuming that another individual will act against my profit or utility (me). A fear component gets introduced here. Because I fear that someone else to act against me, I have to act against him first. Ultimately, we end up in a sub-optimal outcome (the dominant strategy: prison for both). Similarly, I fear Lehman will go bankrupt so I sell the stock, I fear I could be laid-off so I do not spend, I fear the company will do poorly so I cut the rating, …

In the crisis, our expectations coincide with our fears - this is why in 1933 in his first inaugural speech Franklin D, Roosevelt said “first of all, let me assert my firm belief that the only thing we have to fear is fear itself”. Is there an alternative to fear? Is it the latest (all of a sudden) more optimistic news on TV? Maybe not.

I look at those who are fearless, risk-taking and positive even in a crisis - and in fact many of them were born because of a crisis: entrepreneurs. While we have fear and perpetuate self-fulfilling prophecies ending up in a sub-optimal outcome, entrepreneurs have hope and because of this hope they invest what they possess ending up generating a profit. They might also fail. But they have that ‘never give up’ attitude. They would not simply accept a crisis or try to live through it. They would look for solutions. Likewise, entrepreneurs would not simply listen to a prophecy. Above all, they would not simply listen to a prophecy predicting their venture will fail - in fact, they invested in their venture anyway, or they would not be entrepreneurs in the first place. They invested in it anyway not because they were ‘not afraid to fail’ but because they believed they were not going to fail.

So, if crisis is a way of thinking -the word crisis itself comes from the ancient Greek verb krino, which means to decide, to judge, to pick out and choose- the question becomes “What do you think? What do you believe?” You can choose to be someone who believes the prophecy and simply accept the dominant (pessimistic or optimistic) mentality or you can choose to be, as Solzhenitsyn put it, “someone who thinks differently; someone who thinks freely”. If listening to economists, politicians, journalists, forecasts, and probabilities makes you think like you had a predetermined future, then maybe you should turn off the TV and get rid of that business magazine that comes with the mail. Simply do not listen. You are not a prisoner. You are a free man.