"Crises like the current one are inherently unpredictable. "

Greg Mankiw makes a good point:

"Lessons from the Crisis As seen by Michael Spence.

Mike says a lot of smart stuff in this article. But this sentence seems to veer off in the wrong direction, or at the very least could be easily misinterpreted:

we need a commission of top industry professionals and academics to address the challenge of measuring and detecting systemic risk and provide the underpinning of an effective “early warning” system.

I see little hope of creating any kind of "early warning" system, if by that Mike means better forecasting. Crises like the current one are inherently unpredictable. If they were predictable, hedge funds and other money managers would not lose so much money during them."

This is a good point, but not dispositive.

"True, a few people were sounding an alarm in advance of the current crisis: Nouriel Roubini, in particular, comes to mind. And a few hedge funds have made money during the crisis. Yet that fact is not very meaningful. Given the diversity of opinion at any point in time, someone will always look right ex post. The key question is whether the event is reliably predictable ex ante.

Policymakers at the Fed and Treasury cannot do better than rely on the consensus judgment of experts, and a couple years ago the consensus opinion was not predicting anything like what is now occurring. To suggest a regulatory system that gives an "early warning" is like saying we need to find a better crystal ball. Good luck with that."

I think that there's a difference between an early warning system, and deciding what the early warning means. I can certainly think of early warning signs to alert us that we're in need of taking a serious inventory of our circumstances, but whether or not anyone would listen to it any more than any other commission or policy group or whatever is dubious. So, in that sense I agree.

"In my view, the key to regulatory reform is not trying to predict the future with more accuracy but, instead, making the system more robust so that the economy functions better when the unpredictable inevitably occurs. In other words, our focus needs to be not on what will happen but on what might happen."

I'm not sure about the difference between "will" and "might" here. I think that he means we shouldn't try to prevent anything, but be better at reacting to anything. But that can't be right. For one thing, the policies you put in place to react to a crisis are open to the same indeterminacy as trying to predict the exact crisis. You might well prepare for exactly the wrong thing. Also, some things can surely be prevented, so why not prevent them, if you can. True, it's hard to prove that you prevented something that didn't occur, but, it's certainly conceivable that an early warning system could prevent two or three crises, while a robust system fails miserably when the crisis actually occurs.

As an epistemological point, then, I don't see that he has drawn any kind of clear or determinative distinction. The solution is to take a look at both preventative measures and crisis management measures, and employ the most sensible mix of measures that we can agree on, knowing that, well, we don't really know exactly what will happen and when.

One note of major disagreement with Spence:

"Systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."

See, I don't buy that financial innovation was intended to reduce risk. It was quite clearly meant to increase risk, in the hopes of higher returns. Lowering capital requirements, avoiding regulations that are intended to dampen risk, selling products to people unable to afford them under any reasonable scenario, are in no meaningful sense capable of lessening risk.

They were intended to redistribute and hide risk, but not in the way Mr. Spence says. And this is my main disagreement with Prof. Mankiw; namely, one can imagine an oversight group that examines all products that transfer risk to third parties or magnify risk. Since that is why they will, in fact, be created, it is not inconceivable that they can be monitored or, if deemed necessary, regulated. If they can be created by human comprehension, then they can be understood by human comprehension as well. This is actually a version of the fact that whatever can be meant can be understood.