How to Assess True Macroeconomic Risk

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How to Assess True Macroeconomic Risk

By Philipp Carlsson-Szlezak and Paul Swartz | Harvard Business Review Magazine | July–August 2024 Issue

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Over the past five years corporate leaders and investors have had to digest a rapid succession of macroeconomic shocks, crises—and false alarms. In 2020, when the pandemic delivered an intense recession, leaders were told it would be worse than 2008 and potentially as bad as the Great Depression. Instead a fast and strong recovery unfolded. In 2021, when supply bottlenecks and strong demand sent prices soaring, a common view was that runaway inflation would take us back to the ugly 1970s. Instead inflation in USA fell from 9.1% to just above 3% in a year.

For executives and investors such whiplash comes with two types of costs: financial and organizational.  Shocks and crises pose a real threat, but so does overreaction to them. And for every true crisis there are many false alarms. Understanding macroeconomic risk—the potential for negative or positive change, both cyclical and structural—is essential to responding to these threats with rational optimism.

Understanding risk is not about building the right model—no matter what many economists will tell you. To be sure, perfect foresight is impossible even if we look beyond the confines of modeling. But executives can cultivate their judgment—and use it to see past the headlines, to identify key causal narratives, and ultimately to make better calls.

Still, by embracing three analytical habits that can result in better macroeconomic judgment, leaders stood a fair chance of recognizing the false alarms.  These three habit are: 

1. Let go of master-model mentality.  Models are unreliable because macroeconomic relationships are context-dependent and use small sample sizes.  Compounding this problem is the fact that models and their forecasts are least reliable when they are most needed: in times of crisis.
2. Discount doom mongering. Leaders must contend with a constant drumbeat of headlines foretelling disaster. Why the negative bent? Simple: Doom sells. Economic and financial journalists rarely have an opportunity to write about sex, crime, or celebrities. Crises and collapse are reasonable substitutes in a competition to attract eyeballs and generate clicks. Leaders need to choose their clicks wisely and remember who is speaking and from what perch. They don’t have to follow every news cycle that spins the latest data point into a story of collapse. And they must be able to quickly calibrate the stories they do spend time on by asking, simply: What would it take for this to happen?
3. Practice judgment through economic eclecticism. There is an alternative to master models and doom-scrolling. To stand a better chance of getting macroeconomics right, leaders must develop a situationally aware mindset that is focused on causal persuasiveness and coherence of narrative. Inputs to this sort of judgment should come not only from economics but also from adjacent (and far-flung) disciplines and methods. Sometimes frameworks help us understand risks; sometimes historical episodes are illuminating; sometimes even formal economic models can be useful. Narratives about how the system works matter and can be used to stress-test the bold claims in economic debate. And once it is understood that macroeconomics lacks the analytical elegance of, say, physics, leaders can more confidently bring in broader perspectives and methods. Macroeconomics is not best suited to be a soloist; it plays better as part of a band.

The key is an approach that values contextual flexibility over theoretical rigidity, rational optimism over doom mongering, and judgment over prediction.

3 key takeaways from the article

1. Over the past five years corporate leaders and investors have had to digest a rapid succession of macroeconomic shocks, crises—and false alarms.  For executives and investors such whiplash comes with two types of costs: financial and organizational.  
2. Leadership is about navigating uncertainty. If the future were readily predictable, leading would be no more than execution.  Understanding risk is not about building the right model—no matter what many economists will tell you. To be sure, perfect foresight is impossible even if we look beyond the confines of modeling. But executives can cultivate their judgment—and use it to see past the headlines, to identify key causal narratives, and ultimately to make better calls.
3. By embracing three analytical habits that can result in better macroeconomic judgment, leaders stood a fair chance of recognizing the false alarms mentioned above. Three analytical habits are:  let go of master-model mentality, discount doom mongering, and practice judgment through economic eclecticism.  The key is an approach that values contextual flexibility over theoretical rigidity, rational optimism over doom mongering, and judgment over prediction.

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Topics:  Political-Economic Risk, Economic Models, Prediction