Predictability of Financial Crises: Lessons from Sweden for Other Countries

Article excerpt

The predictability of financial crises is widely regarded as low. However, skills linked to market psychology (behavioral finance) and the understanding of history and macrofinancial aggregates have been insufficiently integrated in the forecasting and risk management of financial institutions. Traditional financial modeling can no longer he applied as nicely as in the past. In Sweden, the financial crises of the early 1990s and in the latter part of the past decade were caused by overconfidence, control illusion, and herd mentality--hut also by shortcomings in management and corporate governance. There is no evidence that these two serious Swedish banking crises were not fireseeable. The general question is when and under which circumstances financial decision-makers and authorities should listen to the usual minority of warning voices. One conclusion is that economists should be more "in house-oriented," and top managers should heed their professional opinions. Conclusions from this paper can also be drawn for China, India, and other emerging markets both when it conies to financial deregulation policy and government debt risks in deregulated financial markets.

Business Economics (2012) 47, 262-272.

Keywords: Sweden, financial crisis, forecasting, behavioral finance

It is clear that there are few tasks for economists as compelling as the ability to predict the onset of a financial crisis. Clearly, nowadays central banks want to do this in order to set in motion the actions needed to avoid one. Moreover, if it appears that if a crisis is possible, banks, other financial institutions, and other private actors in the economy need to know of such an eventuality in order to plan and implement defensive measures. However, the predictability of financial crises is still widely regarded as low, particularly in academia and at central banks.

The position of this paper is that this belief can be challenged by enhancing skills that are linked to market psychology (behavioral finance) and the understanding of history and macrofinancial aggregates. These areas of financial market research have been insufficiently integrated into the forecasting and risk management of governmental and private financial institutions, as well as academia.

Using the Swedish financial crises of the early 1990s and the late 2000s, the paper demonstrates that it is time to accept that traditional financial modeling can no longer be applied as nicely as it has in the past. It has been obvious in Sweden that these crises were caused by overconfidence, control illusion, and herd mentality--but also by shortcomings in management and corporate governance. Section 1 of this paper describes the two Swedish crises and reaches conclusions related to the avoidance and correction of future crises. Section 2 describes the areas of research that must be pursued in order to understand risks and to avoid future crises. Sections 3 and 4 examine the predictability of the two Swedish crises, had the understanding described in Section 2 been applied. Section 5 describes general lessons that should be learned from the Swedish crises. Section 6 describes how developing countries, particularly China, can benefit from lessons learned in the wake of the Swedish crises. Finally, Section 7 looks at the predictability of future crises and the role of economists in averting them.

1. Two Swedish Financial Crises

The Great Swedish financial crisis of the early 1990s--Crisis 1

From the mid-1970s, when the consequences of the first big modern oil crisis were felt, until the mid-1990s, Sweden was characterized by significant deficits in national savings. During these two decades, there were only a few years in which the current account was roughly in equilibrium [Lindstrom and Lundberg 1993]. Several devaluations took place during the latter part of the 1970s and during the 1980s, accompanied by persistent inflation problems. …