Can we avoid financial crises in the future?

Robert F. Engle III

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 2003

The ‘premiere econometrician in the world’ is how Robert F. Engle’s colleagues describe him. Throughout his 48-year career he’s developed successful models to measure and predict economic events like financial crises. Though his masterpiece, the ARCH-Model, was developed in the 1980s, it’s still used today as a kind of early financial warning system. Besides his accomplishments in economics, Engle is also a dab hand at time management, because despite having a crammed calendar, he’s managed to reach the peak of success as a semi-professional ice-skater.

A man of many talents

You might just as easily find him sleeping in a tent or a five star hotel, ice-skating in snowy New York or canoeing in sunny California. So it’s no surprise that his biography reads like one long adventure, accompanied by a healthy dose of self-deprecation. Maybe this is why, despite his never-ending string of successes, you can’t help but like Robert Fry Engle III. His family and friends know him as a true companion, a well-oiled machine, a focused economist and beloved family man. And as he opens the door of his apartment close to Washington Square Park, one of those typical Manhattan buildings, with a hint of Gotham City, the Nobel Laureate introduces himself with a firm handshake, welcomes us in, and tells us where it all began.

When Engle was growing up, his father built a workshop where he taught his eldest son about science. So when he wasn’t playing in a variety of sports teams, or practicing the tuba, cello and bass, he was doing scientific experiments. And today admits that some of them were very boyish. "I was a friendly nerd," he says with a blink.

However, even while studying under Nobel Laureate Hans Bethe, he knew that physics wasn’t going to be his future. So after finishing his master’s degree, Engle started taking courses in the ‘soft’ science of economics.

At a glance

Born: 1942, Syracuse, New York

Field: Econometrics

Prize-winning work: Methods of analyzing economic time series with time-varying volatility (ARCH)

Addictions: Espresso

Wasted chances: Research area of his final paper in physics was awarded the Nobel Prize in the same year he received it in economics

Ice-skating trophies: "Too many to count them"

Using economics to answer the most important questions

Engle’s scientific study was vital for his economic research, particularly in the field of econometrics, which uses mathematical and statistical analysis to forecast trends, and which Engle helped pioneer.

He’s developed models that not only serve academics but investors, companies and regulators too. Widely used to foresee volatility and risk in financial markets, it gives answers to the most common questions: What is the tradeoff between risk and return? How do you make money in finance without taking risk? How much risk should you take? How much do you make when you take more risk?

His most profound work, the groundbreaking ARCH-model is "everywhere in finance," Engle admits. He explains that not only has it been the basis for many other more accurate tools, but it also ended up being the reason he changed his focus from macroeconomics to finance.

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Can the ARCH-Model help us predict the future?

The full name of Engle’s model is a challenge for experts, not to mention the average person who wants to invest their savings. "In fact, I have my classes practice this," he laughs. "It stands for: autoregressive conditional heteroscedasticity." Quite a tongue twister.

"I developed this as a forecasting tool to try to figure out when risks were greatest. Taking each movement from one day to the next, and then taking the square of them and averaging them, gives you a sense of how much they move around." But, says Engle, "That’s not a very good way of forecasting. Because it means that you think that the future movements are equally related to what happened yesterday and what happened two years ago."

The ARCH-model was only the beginning of what’s possible, telling economists which sets of data turned out to be the best over a historical period. Engle went on refining the tools to make them more accurate, as he tells us at the Volatility Institute.

What needs to be done after a financial crisis?

Of course, it’s impossible not to ask the specialist who develops the most important forecasting models: why was there a financial crisis? Engle raises his eyebrows. "Well," he starts, "risk was very low and volatility was very low before the financial crisis, but that was a short-run risk. And many people who saw this ended up buying big quantities of mortgage-backed securities and other kinds of assets, and all the things that got people into trouble because they thought risk was low. But it was only low in the short run."

Who was to blame for the financial crisis?

Unlike some of his colleagues, Engle doesn’t blame bankers. He says they wouldn’t have taken so much risk if they’d known they were doing it. "People don’t see what the long-run risks are, they only see the short-run risks. We call this risk myopia. If the risk is really constant at its level, that’s one thing, but if it changes from that level, it can get worse. So one interpretation of the financial crisis is that we need to do better risk management. To make better decisions, have smaller errors and avoid these kinds of events in the future."

What would a new crisis cost us?

Right now, Engle can only forecast one day into the future, but his ultimate goal is to be able to forecast risk months ahead, or even a whole year.

The latest ARCH-version shows how much capital any particular financial institution would need to raise in case of a new financial crisis.

So how much would it cost to rescue the entire banking system, in the event of another financial crisis? Engle smiles. "Today, that number is about $3.5 trillion." This is a big number, he agrees, but insists that this number isn’t as large as it would have been in the years 2011 and 2012, when the sovereign debt crisis was going on in Europe, or not as big as it was during the 2008/2009 financial crisis. "But it’s still a big number."

$3.5 trillion - the amount needed to rescue the banking system after another collapse.

A life-changing prize

The Nobel Prize has given Engle opportunities to do more. The funds that came with it enabled him to found the Volatility Institute at New York Univesrity’s Stern School of Business in 2009. When his wife Marianne remembers the call from Stockholm, she still gets moved to tears:

The last words they said to him were: Your life will never be the same again. Then they hung up.

She takes a deep breath. "And Rob said to me: Oh my God, they said my life will never be the same, what shall I do?" I said: Change your shirt!" She says, laughing. The situation presents a touching insight into how the Engle family deals with communication outside of an academic field: with a good laugh.

At the institute and the NYU campus, Engle is all business, but another side of his personality reveals itself when he’s not on the clock. Marianne, a psychologist, is still surprised whenever Rob steps on stage for a speech. She remembers the first time joining him at a professional event. "There were some questions from the audience and he answered in the most direct, assertive, I wouldn’t say aggressive, but you know, 'This-is-what-it-is' kind of way." She starts smiling. "And I was like, 'woo hooo… he brings this ... confidence!"

Engle, a little bashful, explains: "I want to make sure that every time I give a talk, it’s a good talk." The goal of leaving people with something they didn’t know before steers him back to his home office; the most important recognition is hanging on the wall right next to his desk. "This is a tree", Engle explains. "There is the trunk, and these leaves on the tree are all of my students over many, many years, and their PhDs and the name of their thesis is on here and the year they got it." That they are now economists or professionals on Wall Street fills him with great pride and proves that whatever else he’s pursuing, economics remains his first love.

How can we make better forecasts?

Back in Engle’s Volatility Laboratory (called V-Lab), they run 60,000 econometric models per day. They gather in data from every market around the world to examine and prove theories and explore how volatility changes from time to time, with the goal of coming up with better risk measurements. "He has a gift of taking something as complex as these models and turning them into language that anyone can understand," says Robert Capellini, the Director of V-Lab, who finds him very easy to work with. "He doesn’t put on a show in front of a class, playing the role of Nobel Laureate. He’s always authentic and genuine."

Engle starts talking about a new risk, where the level of risk will change between the short-run and the long-run risk. “It sounds hard to get your mind around, but if the risk is really constant at its level, that’s one thing, but if it changes from that level, it can get worse. And how much worse can it get? We use things like stress tests for banks where we create a scenario and we say: How would the bank do under this scenario? Would it have enough capital? So using the ARCH-model or the GARCH-model (tools for estimating volatility in financial markets) or whatever version of it you’re interested in, you can simulate the worst cases that you might expect for a year from now.” In V-Lab, these processes are done every day and are available on its website.

Rob’s models have shed light on where the risks are in the world.

The man behind the success

Luckily, Engle can delegate some of his work to colleagues and computers. Because even a Nobel laureate needs some down time. So how does one of the world’s most important economists relax? He loves to escape to his lake house in Mahopac just an hour’s drive from the city, where he can fish and unwind with his family. Today, there will be no fish on the plate. But Marianne is happy anyway because her husband makes "the best panini in the world." "Have a seat and try them," she says with a wink. With every bite, we wonder more and more how one of the most important economists today can be a semi-professional ice-skater and such an exciting, lovable husband and father, too. "You just have to decide that it’s not a compromise that you wanna give up. Work hard and play hard," Engle says with a grin, looking like the all-American Mr. Nice Guy - who may, indeed, make the best panini in the world.

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