Economy 4.0

New government unit may predict financial storms

David Brancaccio May 19, 2011
Economy 4.0

New government unit may predict financial storms

David Brancaccio May 19, 2011

Kai Ryssdal: Dominique Strauss-Kahn made bail today. The head of the IMF will be under house arrest in Manhattan while the case against him proceeds. The news of the weekend means even those unfamiliar with international finance now know IMF stands for the International Monetary Fund.

Here’s another one, less familiar, taken straight from the pages of the recent financial reform law: OFR. The Office of Financial Research. It’s a brand new government outfit that, we’re told, is vital to our future financial health.

Our series Economy 4.0 is all about that, how to make the global economy work better for more people. So our special correspondent David Brancaccio has been out playing with metaphors to try to explain what this OFR thing is supposed to do.

David Brancaccio: When the financial storm was howling in full force about two years ago, Penn State professor John Liechty popped over to a workshop on financial risk and statistics, the sort of thing he likes to do.

John Liechty:I’m a statistician, I heard about it, and I thought I’ll go see and what they’re talking about.

What seemed freaky to Liechty was the focus on keeping individual banks safe from disaster.

Liechty: So I raised my hand in this meeting and I said, “Who’s got the data on the entire financial system?” And the answer was that nobody really has the data.

There was a terrifying thought: No one keeps track of the whole kit and caboodle.

Liechty: And then I thought this is dangerous; this is crazy.

That realization sparked a cool idea, but before we get to it, let’s travel back in time to Sept. 8, 1900. Without getting too Ken Burns-y, Galveston, Texas, was the country’s third busiest port; a boomtown with electric streetcars, concert halls and French chefs. That is, until calamity struck.

Caroline Schaper Harris: What time was it when it happened?

A Category 4 hurricane with winds topping 150 miles an hour smashed into Galveston.

Schaper Harris: It was about 1 o’clock in the daytime when that wind and that weather came up.

This was recorded by the grandchildren of Caroline Schaper Harris in 1981. She survived standing on a pile of mattresses in the family’s attic. Eight thousand people died, mostly drownings. There had been no warning at all.

Schaper Harris: They didn’t have things out to, you know, to let people know.

Erik Larson: It was just, I’m sure one of the most horrifying, gruesome moments in continental American history.

According to Erik Larson, who wrote a book about the storm, the forecast for the day was: “fair, fresh, possibly brisk.”

Larson: Even though everybody in that era thought that weather forecasting was a pretty complete science, it certainly was not.

Thankfully, 1900 was not the pinnacle year of our meteorological understanding. But what happened in Galveston ultimately lead to — metaphor alert — the formation of the National Hurricane Center, an agency dedicated to understanding and predicting hurricanes. What does this have to do with the new Office of Financial Research? Back to Prof. Liechty, statistician.

Liechty: If you think about the way science works, first of all it seeks to understand a phenomenon. Then it tries to explain how it works. And ultimately it tries to get to the point where it can predict it. You know so with the weather, where are we at? We understand the weather, we’re able to explain it, and we’re able to some degree predict it. With the financial markets, I believe we’re probably at the point where we’re just beginning to understand it.

Liechty wants the government to treat the markets as a science. So the Office of Financial Research will collect data from the country’s financial institutions regularly, automatically.

National Weather Service: Here is the hazardous weather outlook for South Florida.

Instead of tracking temperatures and air pressure, the new office plans to collect daily transaction logs from the country’s financial institutions. It could look at who’s holding what types of risk, and it will use computer modeling to try to forecast, say, sunny skies over the bond market — or a Category 5 storm bearing down on the mortgage market.

National Weather Service: And now for the extended outlook.

The idea is for this financial storm tracking center: to warn policymakers at the Treasury, the Fed or in Congress as red flags pop up. Professor Liechty thinks had the Office had been in place, it could have caught what he sees as “low-hanging fruit,” like Bernie Madoff’s Ponzi scheme, and maybe even called attention to accidents waiting-to-happen like credit default swaps. But with one big caveat from the professor:

Liechty: One of the interesting things about the analogy, where it breaks down, between the financial markets and hurricanes, is that hurricanes don’t respond to hurricane forecasts.

Meaning: you can’t spook a hurricane and make it worse — but you can spook a market. Government officials will have to be very careful their new early-warning data doesn’t end up causing the very instability it’s meant to predict and avoid.

In New York, I’m David Brancaccio for Marketplace.

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