Propensities, the bad news principle, Brazil and the global financial crisis

Karl Popper, regarded as one of the greatest philosophers of science of 20th century and professor of the London School of Economics who died in 1994 at the age of 92, has a vast range of fields of study, from the way our brain works to thesis on the influence of mass media on the society in general.  However, Popper is better well known, in academic grounds, for his theories on human knowledge and his concepts on objective truth, the conjectural knowledge and on the impossibility of demonstrating positively our theories; ideas appreciated by some, but also very contradicted by others.

But, what is Popper doing on this article about the current economic crisis? We would like to use two concepts proposed by him, as useful instruments in our discussion of today’s economic scenario, added to a concept proposed by Ben Bernanke, the bad news principle, which we will analyze in the sequence.  Even though, these concepts may seem opposite at a first look, in reality, they are intrinsically complementary. The first of them refers to the well known concept of the objective knowledge, or even, the objective truth – truth in conformity with facts demonstration, truthlikeness. The fact of not knowing or not understanding an event does not hinder it from being true. The world was “surfing” on a big speculative bubble, produced along the last two decades; however, most of the analysts and economists were not able to identify it or even to forecast it.  The few of them, who forecasted it with more accuracy, were derided by their “inadequate” forecasts, reminding us the soldier being out of step with his entire troop.

The second important concept proposed by Popper refers to the “propensity interpretation of probability”, in other words, as Popper defines, the propensities inherent to an event; inherent to a situation. Therefore, the world may be seen as a world of propensities, as a process of possibilities that come to reality, and of new possibilities that start to show up. In this way, according to Popper, the future is actively present in each present moment.

The current economic scenario presents an extended range of possibilities, with different weights, some very catastrophic, other less, and some few more optimistic scenarios.  The economic future depends, in great measure, on the individual actions of different countries, but on the other hand, also, and above all, on the coordinated actions among them, given the huge level of interdependence in the resolution of this enormous crisis.

The current propensities, obviously, are not the most promising, as the state of insolvency of some national financial systems attest, including the American one. Modern economic theory, focused on the study of business cycles and on investment theories, present a very important result, and at the same time very intriguing: the bad news principle. In scenarios of uncertainty, the decision of investing, or of delaying an investment, depends exclusively on the size of the scenario of losses and its probability, and does not depend on the size of the good scenario, not even, for example, on the existence of a reasonable expected gain (profit).  In other words, while there is a possibility of a world catastrophe, even if weighted by a small probability of occurrence, or a small propensity – to use our popperian jargon – investments on different economic sectors will remain frozen. We can here understand investment on a more vast sense: from investments in fixed capital within the companies, to credit offers by financial institutions, which see it as their investments. Even the consumption of durable goods, by households, could be thought of as an investment, and therefore influenced by this principle.

The bad news principle may seem obvious in its proposition, but its implications are not so obvious. Every decision of investment is taken based on the comparison of a future scenario projection and a determined cost of opportunity; in more technical words, we divide the expected cash flow by a specific interest rate of opportunity.  The expected flow, on its hand, is based on a probability distribution, or to say, in possibilities of gaining or possibilities of losing. We could, for example, “expect” a profit of US$ 5, considering a structure of gaining US$ 20 with 50% chance and losing US$ 10 with 50% chance. The bad news principle shows us that the decision of investing or of delaying an investment depends, obviously on the interest discount rate, but also on the size of possible loss and its probability. In our example above, it would depend on the 50% probability of losing US$ 10. This is because, on this case, in which a possibility of losing exists, the scenario of profit does not have any influence on the decision of investment, even if it would be higher, for example a 50% chance of gaining US$ 50.

Such implication shows us that along with a reduction of the interest rate, to reduce the cost of opportunity, the central banks and government around the globe, need to reduce substantially the possibility of a big loss scenario. The proof of such proposition is that in most of the developed world the interest rates of short-term are already very close to zero, and we continue to see a global slow down. Even the most incredulous would say that such proposition is obvious: With all the uncertainty reigning, everyone is desperately frozen. The bad news principle shows us, however, that from the economic theory point of view, it is an optimal decision of the economic agents, to not invest, in front of an uncertain scenario, or better, to delay investment. However, such individual action is catastrophic in a macroeconomic point of view.

The presented result is known as an important cause of business cycles. In the current crisis it can give us good insights to understand the sudden stop of the world economic level of activity, since the third quarter of 2008. The recipe, however, to face the bad news principle, is to, more than putting down the interest rates to levels close to zero, reduce rapidly the level of uncertainty and the perception of a possible economic cataclysm.  For this, it is unavoidable to have a coordinated action, fast and efficient, of the government of USA, EURO zone, Japan and the BRICs (Brazil, Russia, India and China), or to say, the G-20. The interesting fact of all this is that the “discoverer” of the bad news principle is nothing more than Ben Bernanke, the current president of the American Central Bank, one of the main leaders of the economic programs  that may take the globe out of this economic abysm.

With the financial system frozen because of the lack of credit, which today is scarce, and therefore, very expensive, and with a very low propensity of the business world to invest, the restart of the productive activity around the globe is hindered. With the economic activity in a strong slow down movement, the international trade flow also hinders, which motivates protectionist actions in different countries.  This is all the world does not need at this moment.

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The great problem of this sudden stop is that if for some it is optimal to wait, the stop for others means to go belly up, which means raising delinquency and additional provisions and loss on the banks side.  It is the world of propensities weighing more to the side of bad news. There are, hence, innumerous and enormous problems to be confronted to stabilize this crisis. The costs for the resolution of these problems will leave scars for decades.

The biggest problem of all – in absolute terms, it is important to empathize – will be to save the American financial system, which has already begun with the rescue and mergers among innumerous institutions of the size of Bearn Stearns, Merrill Lynch, Fannie Mae e Freddie Mac, Wachovia, Washington Mutual, Countrywide, AIG, not forgetting the explosive “let it fail” of the Lehman Brothers, which continues with the recent Citigroup bailout. This last one had a value of US$ 255 billions in the second quarter of 2007 and these days it is worth around US$ 15 billion (see Graph). The graphic speaks for itself, and also proofs the concept of objective truth. The fact of not having been aware of the magnitude of the financial disequilibrium, which built itself along these last two decades, does not mean it did not exist, it was not real. By the dimension of this crisis, its development will have a structural impact in the world economy. But the worry with these structural impacts post-crisis should be thought of and worked on more ahead. The debate about the efficiency of the anti-crisis measures has almost no relevance; the most important is the urgency of proposing solutions.

So, what are the main structural impacts on the world economic system for the next years? Probably, the most important impact will happen on the financing structure among countries and its effects on the costs of their respective debts, with implications on the real side of economy and on the welfare of their citizenship.  In other words, the current world economic structure, based on the enormous savings disequilibrium between countries – USA with huge deficits and China with enormous surplus – will not persist, even if on the current peak of the crisis we have the feeling that the world continues financing the USA in the same format pre-crisis.   Americans will be obliged to live with a higher interest rate, forcing a higher level of savings and also a devaluation of their currency below the current level. About the dollar, our hypothesis can be explained by the metaphor of the tsunami:  before the great wave of dollar devaluation, there would be a movement of revaluation of it. Our hypothesis shall be tested in the next months, quarters. China, on its hand, will be obliged to transfer part of its structure used for exportation to attend its growing domestic market. Crude oil will continue to have its economic value for decades, until we discover the miraculous cell of hydrogen in an economic feasible scale. This implies that the main producers of crude oil will continue to have current account surpluses:  will continue to distribute savings to the rest of the globe. What else could we speculate, besides all this? Regarding Brazil, it continues to feel strongly the effects of the international crisis, giving signs of the strong economic slow down with repercussions on public accounts, indicators of delinquency of the banks, and indicators of unemployment, among others. The last two indicators of economic activity have shown the sudden economic Brazilian stop in the forth quarter of last year and also on this current quarter. The GDP fell 3.6% in the fourth quarter of 2008, comparing to the previous quarter. The dive of investment, gives an example of the bad news principle: the indicator dropped 9.8% in the last quarter, comparing to the previous one, on the series with seasonal adjustment. This was the highest decline since the beginning of the release of this data in 1996 (see figure bellow).

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On its side, the results of the industrial production research of last February, released by IBGE (Brazilian Institute of Geography and Statistics), on the 6th of march, was also very bad, the indicator fell 17% against the same month of last year. With the current world scenario, the directors of Central Bank have decided unanimously to reduce the basic interest rate (Selic) to 11.25%, a reduction of 150 basis point.  This process of monetary easing will continue in the next months in order to face the drop on the level of economic activity.  Analysts estimates, based on the recent news, are that the GDP will be negative in 2009. Believing that the second half o 2009 will be of a gradual resume of investments and production, with the reduction of the uncertainty level in Brazil, we estimate a GDP between 0 and 0.5% in 2009. Regarding the external sector, we maintain our previous projections of a drop of 25% on the level of our export and imports, and also our projections of an exchange rate bellow R$ 2.00/USD by the end of 2009.

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Independently of the scenario that will present itself in the next years, on the middle-term we believe that the Brazilian economy will, in relative terms, come out stronger from the current crisis. With the new Brazilian discoveries of crude oil, and with its competitive energy matrix in relation to most of the other countries, Brazil may have a very well balanced current account in the years to come.