"You can smell the brakes getting hot," said a friend, a longstanding critic of the world financial system. In his view, this is it, early evidence of The Collapse. How it will happen, we are not quite sure, of course. His guess is just that, a guess - but is it any worse than that of people who have modelled entire economies? The Russian crisis and falling Western stock markets are forcing us to recognise the limits of the predictive value of economic analysis. The acres of analysis that has been printed over the last three weeks has been high on descriptions of observable phenomena - devaluation, default on Russian government debt, queues at Moscow banks, plummeting and yo-yoing stock markets and so on. It has been very low on convincing predictions of what will happen next to Russia, to stock-markets and to our economy.
It is like watching World Cup soccer, a distant and fond memory now. The panellists give real-time tactical analysis and advice, but in terms of predictions we are often left with, effectively: "If the ball goes into the net, it will be a goal." And if asked to predict a scoreline, they will offer, for the hell of it, 2-0 or 3-2 or whatever. The analysis is the serious part, not the prediction. So it is with Russia and the world economy. What has happened in Russia and what is happening in our stock-market is being explained in relation to its proximate causes and their immediate effects. Three areas are to be watched for the effects of the Russian crisis: trade, commodity markets and investors' confidence. But the external shocks of devaluations and loss of confidence, and the bottom falling out from under assumptions are factors not built into the equations, I would think.
The crisis is bringing us back to the primacy of political conditions and underlying attitudes by investors, large and small, to risk and the unknown. The crisis in Russia stems from a political problem, crystallised in the person of Mr Boris Yeltsin but going much deeper than his lack of leadership to an absence of sufficient political consensus about the basics of democracy. To say that the Russian crisis will be solved by putting in a good leader and a government is no better than saying that a goal will be scored if the ball crosses the line. It's true, but it doesn't address the real problem. One can describe possible political or economic outcomes in Russia. One can speculate on the possible level of the ISEQ now that the assumption of a benign international environment is crumbling. The hard part is to argue convincingly how probable each scenario is - is it 5/1 or 50/1? Only by ascribing probabilities does an analysis leading to prediction have any real value. To ascribe a probability to the emergence of a solid political, institutional and social framework in Russia is a qualitative judgment, a guess, well beyond the scope of economic models.
On both counts - the possible scenarios, and the likelihoods for each - the analysis in the serious press is effectively admitting: "We don't know." We are merely guessing at the nature of possible outcomes of the contagion effect, because part of it is caused by loss of investor confidence. As with Russian politics, we cannot apply a mathematical formula to calculate the probabilities of such outcomes. We merely assume that damaged investor confidence in emerging markets, in start-up companies and in growth stocks will account for so much loss in the value of stocks, and then proceed with our calculations. Some will argue that markets, the aggregate of every participant's opinion, are converting such assumptions into reality. Perception, or confidence, is reality in financial matters. In current circumstances, this would mean that the world crisis is over-stated, since most developed country stock markets are far from collapse.
It's not as comforting an argument as it seems. Many funds must stay invested in equity markets or even in Russian debt, come what may. For Ireland, no one seems to have put forward a model of the effects of stock-market falls in the US, Germany and Japan (or Ireland?) on "the real economy" of jobs and businesses here.
Finally, crises and catastrophes require, by definition, that investors are hurt, and badly. Otherwise they would not be crises or catastrophes. It is a logical condition of crisis that the consensus opinion will prove to have been too benign. You don't get to smell the brakes until it's too late.
Oliver O'Connor is an investment funds specialist
