According to the traditional business cycle view, economic booms and busts follow each other in steady, lengthy intervals excepted only by some temporary breaks. In 2007, Alan Greenspan, the former president of the Federal Reserve of the United States, stated, however, that the global economy has entered a new era, characterized by an ever-increasing uncertainty, turbulence and chaos.
Uncertainty met by firms
Even though Greenspan’s statement has not gone without disputation, it is evident that the European debt crisis makes Finnish and European companies to operate in a markedly risky environment currently. Compared with the economic or business cycles usually faced by firms, many matters are harder to manage as uncertainty has increased to exceptional rates.
Three degrees or levels can, with a little generalization, characterize uncertainty met by firms:
- The future may be fairly clear. Risks are modest and their effects on firms can be evaluated and approximated rather easily.
- The future is far from clear. Firms face several alternative paths generated by potentially possible economic policies and events. If firms want to protect themselves, they must be prepared for more than just one outcome, and the same hold true if firms aim to take advantage of the opportunities commonly available in risky conditions.
- The future is characterized by a full spectrum of alternatives. The behaviour of the core variables can still be observed and understood, yet the probabilities for alternative paths are incalculable. The future is dictated by such a major uncertainty that it can be seen as chaotic.
It seems clear that, currently, the European firms face the second degree of uncertainty. No single solution exists for the European debt crisis but is it still, with a reasonable certainty, possible to estimate the economic effects of its alternative solutions and outcomes.
Uncertainty hits both firms and forecasters
The rise of uncertainty makes both the firms’ and the business cycle forecasters’ life harder. The techniques for traditional business cycle forecasting have decisively advanced during the past few years and it is now possible to predict the turning points of standard business cycles with marked certainty by using the modern forecasting tools. During a crisis, however, the traditional forecasts are vulnerable as it is difficult to predict the likely outcome of the crises. The future of Europe, for example, depends on the decisions made by politicians and citizens. If the citizens of Greece decide not to stay in the Euro zone, the exit of Greece will become nearly inevitable.
Firms are able to prepare for uncertainty from the debt crisis using scenario forecasts. Scenario forecasting is a new technique where the probabilities for
mutually exclusive future alternatives are estimated explicitly. Obviously, there are amble different alternatives but, for practical reasons, one must concentrate on such a number which is possible to comprehend. At the present, GnS economics forecasts by using three scenarios, rendering the most probable, the most optimistic, and the most pessimistic forecasts for the on-going crisis. Supported by these scenarios, firms are able to anticipate and manage the risks induced by the European debt crisis.
Scenario strategy to protect firms
The rise in uncertainty makes the operation of firms more difficult because of the substantial increase in the market risks. Firms actively monitor business cycle forecasts nowadays, but during crises, the ordinary business cycle forecasts are often of little help. In the worst case, they may be detrimental and lead astray. Underestimation of risks may lead to deficient strategies and so does overestimation. In crisis, such as now, it is necessary to build a general view for alternative scenarios and to try to prepare for them.
Using scenario forecasts, the business management can choose strategies based on each scenario. It is imperative for firms’ success to develop scenario strategies in the ongoing crisis. At least, scenario strategies are necessary for investments and enlargement plans. The use of financial instruments in hedging against the risks should be based on scenarios because the pricing, the timing, and the degree of the optimal hedging greatly vary across the alternative outcomes of the crisis.
The most prominent advantage of scenario strategy planning is the fact that, when it is constructed, firms prepare themselves for different outcomes of the crisis in advance. If, say, the optimistic scenario changes to the pessimistic one, there already is a feasible strategy to be implemented by the firm. In the next blog entry, we will shed more light on the risks the European debt crisis inflicts for firms in Europe and worldwide.
Tuomas Malinen, PhD (econ.) Principal economist
Tel: +358 40 196 3909
Ulla Lehmijoki, professor Chairman of the board
GnS economics applies cutting edge academic research. We aim to offer the best possible information and analyses to support our clients’ decision making in the competitive global markets. Amid short term fluctuations, it is imperative to have a clear view on the long-term economic outlook in order to be prepared and to maximize the opportunities.