November 04, 2010

Recession, Recovery and Scenario Planning: Which Way Now?

by Patrick Marren and Peter Kennedy  
 
Alas, we are not manufactured, in our current edition of the human race, to understand abstract matters — we need context. Randomness and uncertainty are abstractions. We respect what has happened, ignoring what could have happened. In other words, we are naturally shallow and superficial — and we do not know it. This is not a psychological problem; it comes from the main property of information. The dark side of the moon is harder to see; beaming light on it costs energy. In the same way, beaming light on the unseen is costly in both computational and mental effort.
— Nassim Nicholas Taleb, The Black Swan
 
No one knows what is going to happen with respect to the current recession. (Yes, we know the National Bureau of Economic Research has declared the recession long over, but with 9.6% unemployment, it’s not quite a party yet, is it?) There are experts saying that we’re headed for a double-dip recession. And there are others who worry about an anemic recovery, with prolonged high unemployment, unless the government substantially increases its stimulus spending. Still others insist that recovery is possible, but only if taxes and spending are substantially cut. And so on. So how can we tell what’s actually going to happen?

Well, the bad news is, we can’t, at least until it happens. But there is actually some useful information contained in the very first sentence of this article, believe it or not. No one knows. A lot of people on television and in print and on-line are constantly straining – many for very good pay – to appear as though they DO know exactly what is going to happen. They are called “experts.” “Experts,” in this case, are people who have (or, in some far-too-common cases, merely claim to have) all sorts of rules in their heads about how the economy is supposed to work.

Some of these rules are derived from textbooks. Others are derived from experience. But all of them have a couple of things in common with each other. First, they are all “if-then” statements, theories of causality, e.g.: “If you raise taxes x%, you will stunt GDP growth by y%,” or “If you increase the deficit by α, you will raise interest rates β%.” Second, they are all derived from the past. At their best, these masses of “if-then” statements cohere into an integrated, internally consistent model that elegantly describes how the economy has worked historically.

So expertise is always about the past. But there is no data about the future. And one thing we can be pretty sure of is that, even though a lot of stuff has happened in the past, not everything that CAN happen has already happened. And that things will occur that will contradict the experts’ economic models.

So how do you deal with that? What’s next, more recession, or a real recovery, or something else? Well, you cannot get “the answer” from the experts. Experts are necessary and useful people, but if you ask them about the future, they will have to fall back on their expertise, which by definition rules out events that contravene their elegant models.

The way to deal with this problem is simple: Don’t assume any particular model of the future is correct. In fact, don’t use pre-existing “models” at all – at least when trying to anticipate the future. And put aside – forever – the planning utility of a single “most likely scenario.” Instead, posit a systematically varied array of possible futures – irrespective of their seeming probability or improbability. Then, for each “future,” try to imagine a logical path from today to that future. Often these paths will seem to violate the causalities assumed by conventional wisdom. That’s not a bad thing – it’s a good one. The exercise of imagining alternative logics will actually be worth more to you than any one of the alternative futures you cook up, because it will force you to imagine different ways the world might evolve.

In order to do this, to break out of the past-focused shackles of expertise, you’ve got to make a leap forward, and then work your way backwards from what might seem at first blush to be an illogical or improbable future. This is where experts really CAN help you: they will have the expertise to imagine various plausible, logical ways in which we could possibly get from today to those posited futures.

Five years from now when we look back at what actually did transpire on the economic front, many people may be surprised to discover what they missed, perhaps because some experts were so convincing in their neat predictions. Reality will have proven to be, once again, more complex and messy than most experts allow.

The solution is not to reject experts or expertise, but to understand their limitations when it comes to predicting essentially unpredictable conditions – and their great usefulness in helping us to sketch out alternative futures once those futures are posited. Rather than letting history lull us into thinking the future must be a continuation of the past, and constrain our understanding of plausible future market or operating conditions, we need to use expert knowledge of the past as a starting point for thinking more broadly about possible future scenarios. Force yourself to consider in an organized fashion a systematically varied range of future conditions, then cogitate as to how we might reach those futures. This kind of expansive, scenario-type thinking will produce real insights to guide you as you face tough decisions in the challenging months and years ahead.

Patrick Marren is an FSG principal. He and Peter Kennedy are principal scenario consultants on FSG’s Recession/Recovery Scenario Project.

Thoughts?