Predicting Financial Crisis with Causal AI
In 1933, President Roosevelt signed the Tennessee Valley Authority Act (TVA). This provided flood control to the Tennessee Valley but was, more importantly, a means to deliver electrical power to critical parts of Appalachia. Large reservoirs were formed, and homes were displaced by damming significant rivers in the region. TVA has constructed 29 hydroelectric dams, a pumped-storage plant, and three nuclear plants that provide over 27,000 megawatts of electricity in the following years.
Ten years after the TVA Act was signed, the Oak Ridge National Laboratory was erected a few miles from two hydroelectric dams. As a vital part of the Manhattan Project, much of the activity at the lab was classified. The facility's original purpose was Roosevelt's Uranium Committee [Quist 2000]. While Los Alamos, New Mexico, constructed the atomic bomb, Oak Ridge, Tennessee, quietly produced the Uranium.
In the years following World War II, inflation jumped to over 20 percent. Manufacturing disruptions, rising demand, savings, and money growth [Beilfuss 2022]. Since then, there have been six times that inflation was 5 percent or higher. This occurred in 1950–51, 1969–71, 1973–82, 2008, and 2022, with a peak of 9.1% in June 2022 [Iacurci 2023].
Perhaps surprising is that inflation does not hit all areas of the economy equally. For example, services like haircuts remain static while food prices, housing, and entertainment rise dramatically [Gillman 2022]. At the same time, the increase or decrease in gasoline prices does not usually follow inflation. The gas supply and demand, coupled with an active futures market, makes it possible to have low gas prices during high inflation and vice versa.
Billionaire investor Ray Dalio explains, "There are two main drivers of asset class returns - inflation and growth." The desired inflation rate is the one that improves productivity. This productivity measures living standards created by the efficiency level within a day's work [Dalio 2022]. However, strong economic growth and low unemployment drive up inflation. Central banks often alter monetary policy to maximize these times of economic growth, but this has a side effect that ultimately weakens the future economy, creating periods of boom and bust.
Interest rates begin from monetary policy by central banks, measuring how much money and credit is released into the economy. When interest rates rise relative to inflation, the price of equities and other income-producing assets decreases [Dalio 2022]. This is because such action lowers incomes or the money one invests.
As central banks lower interest rates, they increase the credit available to encourage borrowing and spending [Dalio 2022]. This is done through selling bonds by investors and buying inflation-hedge assets such as precious metals. When interest rates increase, it has the opposite effect.
When credit increases relative to GDP over a period of time, it creates a "Credit Boom" [Gorton 2023]. These booms are usually the predecessors to the financial crisis. When credit is cheap and income is high, people tend to become more lax with spending and lending. Eventually, the income and credit go down to reveal the underlying problems.
As TVA opened more electric facilities in East Tennessee, the economy shifted further away from agriculture. Many of the farms that had sustained generations were now underwater - literally. Those who had survived the region's flooding were hurt by debt from the Great Depression and World War II. This forced many residents to seek employment from TVA and increased the standard of living for the region.
Fast forward ten to twenty years and more people in the Tennessee Valley received college degrees. Unlike other parts of the country with skilled factory jobs, TVA required a highly educated workforce. In 1957, The University of Tennessee created a Nuclear Engineering program, the first one in the country—a direct result of TVA's desired shift from hydroelectric to nuclear power generation.
The 24 years after President Roosevelt signed the TVA to the first nuclear engineering program in the country, they changed an entire region of the United States. Similar occurrences can be seen with Huntsville, Alabama, and the Space Race, another area selected from TVA power generation.
There is a causal relationship between TVA, the Manhattan Project, the Space Race, my dad working at the Oak Ridge National Laboratory, and my Scoutmaster being a Nuclear Engineer. If TVA did not exist, then it is not a stretch to imagine a different reality where Uranium was enriched somewhere else, and the Tennessee Valley was left to moonshiners.
This alternative reality is called a counterfactual. It imagines a new scenario based on changing something in the past. Often a central premise to time travel fiction. For example, what would the average home price be if mortgage rates hit 10%? What about 2%? The fact that a causal correlated relationship exists between mortgage rates and home prices makes such a calculation possible.
In the past, most trading decisions were made based on correlations between some asset and something measurable. For example, if YouTube has 20 million visitors today, Apple stock goes up. Since the causation is unknown, predicting this is also unknown using standard deep learning models. It is possible to predict correlations, but the accuracy of the calculation is based on how much of an actual causal relationship exists between the correlated variables.
A better alternative is causal inference. This is measuring the causal relationship between two or more variables and using those precise measures to predict the future states. For example, the retail price of lumber, the cost of diesel, and new home prices all share a causal relationship. If the price of lumber or diesel increases, the cost of new homes increases. Other causal relationships are not so obvious.
Causal AI finds causal relationships that are not easily determined. These may include weaker or multi-tier relationships such as gasoline futures (RBOB), the federal reserve rate, and the annual cost of wildfires. A fabricated example, these causal relationships exist and provide new insights into what will happen next when coupled with private organizational data.
In June of 1933, President Roosevelt enacted another central act known as Glass-Steagall. This legislation separated commercial banking from investment banking and created the Federal Deposit Insurance Corporation (FDIC) [Federal Reserve History 2013]. At the time, there was a concern about losses from the commercial banking and payments system from volatile equity markets.
A large part of this act placed more regulation of national banks in the hands of the Federal Reserve System with a requirement for annual reporting by banks to the Fed. A move similar to post-2008 bank stress testing. In addition, the FDIC insured savings at commercial banks but did not cover losses from investment banking. A safeguard to increase the population's trust in banking at a time when bank runs were occurring.
This act, along with many to follow, effectively separated the economy into a natural one based on supply and demand and an artificial one controlled by the Fed. When needed, the artificial economy can change the natural one by increasing or decreasing the money supply and credit. Like a dam to prevent floods, the system is far from perfect.
Today, almost all financial metrics have a causal relationship with the Federal Reserve Rate, which controls inflation. These, in turn, influence the housing price, the availability of rental property, and how much will be spent over the holidays, among many other factors. Knowing that a financial crisis has the highest potential after a credit bubble and that a central bank controls credit, it is not difficult to determine when a problem will occur.
However, other factors can expedite tragedy or stop a crisis, such as the TVA for East Tennessee or Glass-Steagall for protecting savings. This type of legislation is talked about long before it becomes law. However, the probability of becoming law ebbs and flows during the cycle. For example, Glass-Steagall only passed after the FDIC was added and still needed a session of Congress to pass.
Such events, nationally and more so today than in 1933, internationally, create cycles of booms and busts—times of invention and wealth creation followed by times of violence and despair [Dalio 2022]. If we are in a cycle of despair, look for legislation that opens the door for invention. During a boom cycle, watch out for the debt bubble.
- Beilfuss, L. (2022) Why the Postwar 1940s May Tell Us More About Our Inflation Than the ’70s. Barrons. https://www.barrons.com/articles/us-economy-inflation-week-in-review-51648252813
- Dalio, R. (2022) It Starts With Inflation. LinkedIn. https://www.linkedin.com/pulse/starts-inflation-ray-dalio/
- Federal Reserve History (2013) Banking Act of 1933 (Glass-Steagall). Federal Reserve. https://www.federalreservehistory.org/essays/glass-steagall-act
- Gillman, M. (2022) The Spectre of Price Inflation. Agenda Publishing
- Gorton, G. (2023) Macroeconomics and Financial Crisis: Bound Together by Information Dynamics. Princeton University Press
- Iacurci, G. (2023) Here’s the inflation breakdown for October 2023 — in one chart. CNBC. https://www.cnbc.com/2023/11/14/heres-the-inflation-breakdown-for-october-2023-in-one-chart.html
- McGee, R. (2015) Applied Financial Macroeconomics and Investment Strategy. Palgrave Macmillan
- Quist, A. (2000) A History of Classified Activities At Oak Ridge National Laboratory. Oak Ridge Classification Associates LLC. https://www.osti.gov/opennet/manhattan-project-history/publications/ORNLClassifiedActivities.pdf