Is extreme event predictable?

Historically speaking, economic crises or disasters natural or man-made have never occurred in isolation. There have always been warning signals which, many a times, were not heeded.

Extreme events do not come out all of a sudden; their trend and information are always available through data points. However, those data points are often ignored and it is believed that nothing will happen, but that ignorance has been proven to be costly in the past. If any of those past extreme events are analysed, it could be found that the vital signs were available but ignored, resulting in a disaster/crisis.
 
In the sinking of the Titanic in 1912, it was “overconfidence” about the ability of the ship not to sink keeping few lifeboats and that too for other sinking ships.
 
The Chernobyl disaster in 1986 in USSR was a combination of a design fault, safety system intentionally turning off, and safety negligence.
 
In the Bhopal gas tragedy in India in 1984 where thousands of people died and health of millions got affected due to the emission of a poisonous gas in the atmosphere, the prime cause was a reduction in maintenance expenses by the management, leading to poor upkeep of the plant.
 
The Indian government and local activists argued that slack management and deferred maintenance created a situation where routine pipe maintenance caused a backflow of water into a tank, triggering the disaster. Union Carbide Corporation contended that water entered the tank through an act of sabotage.
 
The Wall Street crash in 1929 in the US leading to the beginning of 12 years of the great depression was not without warning signals. Prior to this crash, the world was recovering from the First World War, the American economy showed ominous signs of trouble with declining steel production, construction was sluggish, automobile sales were down, and consumers were building up high debts because of easy credit available. Despite all these economic troubles, the stock market was showing signs of high and the gains continued almost unabated until early September 1929. The market had been on a nine-year run that saw the Dow Jones Industrial Average increase in value tenfold, peaking at 381.17 on September 3, 1929, shortly before the crash.
 
The dot-com bubble had a similar story during 1999-2002 when the Internet and World Wide Web (www) was getting popular. At that time, investors were eager to invest in any venture that had Internet or “.com”, and venture capitalists, eager to profit on this investment demand, moved to raise and invest capital faster and with less caution than usual.
 
A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics, such as P/E ratio, in favor of basing confidence on technological advancements.
 
A very recent 2008 economic crisis is still fresh in the memories of people on the back of skyrocketing home prices in the US, cheap credit which made it too easy for people to buy houses or make other investments based on pure speculation lending loan without collaterals, private equity firms leveraged billions of dollars of debt to purchase companies and created hundreds of billions of dollars in wealth by simply shuffling paper but not creating anything of value.
 
In all abovementioned examples of economic crisis over a short history of last 100 years, there were clear signals of extreme optimism or a sudden rise in a particular phenomenon (dot-com) prior to the debacle. The public just followed the general public sentiment and kept investing in any market that gave them return (stock market or housing) in a hope to book quick profit. Even for other disasters, there were good reasons that were not well read by the people/management. There are many other examples in the history proving that extreme events do not occur in isolation without warning signals. The warning signals may come from many sources. In today’s world, global warming is impacting the weather conditions worldwide, which is a signal of a possible debacle that may be sitting in store, and should not be taken as an extreme event, if it occurs.
 
The information available in the world at a point of time if analyzed properly may give an indication of tomorrow’s debacle. The efficient market hypothesis developed in the 1960s in financial economics states that asset prices fully reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.
 
Similar to the stock price, all data available in the world till today carries all information about possible tomorrow’s debacle. Such information is in an advanced stage of development and may be observed in the five fundamental building blocks of our existence. These five building blocks are Earth (Birth), Air (Life), Water (Growth), Space (Purpose), and Fire (Death).
 
These five building blocks of existence are the key, and information about these may act as a key indicator of any untoward incident that may happen tomorrow. The “Earth” is related to agriculture, useful and precious mineral deposits, petroleum output, water deposits essential for life, etc. It is also related to destruction through an earthquake and volcanic eruption, etc.
 
The second component, “Air”, is related to life for breathing as a key component for the survival of humans and plants for photosynthesis; extreme pollution is linked to the destruction of mankind, and extreme wind is related to destruction through tornado-type events.
 
The third component is “Water”, again one of the key survival components for mankind that is useful for drinking, agriculture, etc. Excess or shortage of water is a threat through flood or excess rain or drought impacting the ability to drink as well as produce foodgrains. These three fundamental components form the basis of any economy and demography in the world. The other two components, “Space” and “Fire”, are enablers/facilitators for survival in conjunction with the first three elements.
 
The entire economic and demographic developments are, therefore, a combination of the five essential components of which humans and the world are made up of. It is impossible that impacts on the building blocks are not made before any major disaster.
 
The other ways of destruction could be from manmade creations. In the current context, this could be due to the use of a weapon of mass destruction or terror attack or extreme climate conditions, human behavior such as too much optimism, overconfidence, part of the masses, greed, etc.
 
So any ominous sign of a future disaster will always be available either individually from any one of the five fundamental elements or in one or more combinations of these five fundamental elements. All examples of the stated debacles have shown the involvement of human behaviour.
 
The Titanic incidence was due to overconfidence; the 1929 stock market crash where people followed the masses without looking at the actual economic reality, and similarly, the burst of the dot-com bubble was a combination of greed and quick profit; while the 2008 economic crisis was due to many factors of human behaviour. The tragedies that resulted in the loss of lives are attributed to either negligence, not following the process, or management responsibilities.
 
None of the abovementioned debacles over the last 100 years impacted any of the individual five fundamental elements directly, but rather, the impact was in a form of a combination as “economy”. However, this is changing now, and the current signs are more ominous than ever before, coming from “Air”, pollution, change in environment leading to extreme weather conditions; “Water”, in a form
of water shortage, excess rain or drought, increase in the acidic nature of sea impacting the coral reefs slated to be the lifeline of the aqua world, rise in sea temperature, etc.; “Earth” urbanisation, reduction of forests, rise in temperature, etc. These will fundamentally impact the
ability to grow food as well as have safe drinking and places to live.
 
The World Economic Forum (WEF) every year since 2008 comes out with a list of risks impacting the world on both likelihood and impact scale. These risks fall into five broad categories of Economic, Environmental, Geopolitical, Societal, and Technological fronts. These risks may be compared with the fundamental building blocks of “five elements” and “manmade” creations. Economic and
Environmental fall under the five fundamental elements, Technological falls under manmade, and Geopolitical and Societal are a combination of the two.
 
From 2008 to 2010, top five risks reported by WEF in terms of both likelihood and impact came from Economic, Geopolitical, and Societal risk categories, of which, the top two risks were from the Economic category. From 2011 onwards, risks from the Environmental category started figuring out till the latest report in 2018. Also, from 2012 onwards, a cyberattack on the Technology category started figuring out till 2018. Economic risk was not figuring out in the last three years. From 2015 to 2018, the key risks coming are from the environment, geopolitical, and cyberattacks.
 
Based on this observed global trend over the last 11 years since 2008, there have been drastic changes in the top five global risks which are clearly evident in the five key elements of the building blocks. The air quality is getting poor, resulting in diseases; there is a sudden eruption of air purification market indicating the nature of pollution. At the global level, there have been changes in the climate with extreme cold/heat, rain, flood, etc. Similarly, information technology and digitalization have taken over the entire world exposing the risk of total collapse due to cyber and similar attacks.
 
The way stock price carries all information, similarly, all information available in this world carries an out likely tomorrow, and any event that may dismantle the world impact should not be taken as an extreme event because signals were coming. It is a different matter that no device is prepared to interpret such information and decipher the conclusion. Though the mathematical, econometrics, environmental, and seismic models, etc. are available, neither a combination of all models nor incorporating any human behavior is available. At times, models are more complicated compared to using common sense that can read an obvious writing on a wall. The need is being unbiased. 
 
About the Author:
Sonjai Kumar is Vice President (Business Risk), Aviva India Life Insurance & India Ambassador of Institute of Risk Management, London.
(The article was first published in the magazine 'Legal Era' and it is being published here with the author's permission.)

 


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