Monday, March 2, 2009

On Predicting the Economy

To make business plans or retirement plans or even plan for a summer vacation, we'd like to take into account the future of the economy. If things are to get worse, we need to go conservative. If they'll pick up in six months, we'd like to start paddling out into the surf so that we're ready to catch the next wave of growth and prosperity.

Since we're not economic experts, we rely on the opinions of those who spend their days researching the economy, interviewing people on the economy, and helping to set government policy concerning the economy. That's probably why CNBC has record ratings during this economic crisis. We crave expert advice.

Which brings up an important point: can the experts be trusted when they make pronouncements like, "The next six months will be rough, but I see us getting back to steady, albeit slow growth in the last half of the year."?

Unfortunately, I don't believe there's adequate evidence that the experts can predict the future of the economy. Here's why...

1) Governmental figures and most heads of companies have every reason to bias their reports toward the positive. This is shown on a smaller scale by how CEO's of failing companies keep giving hope to their employees and stockholders, even when all the facts in their grasp tell them that the company will fold completely in six months. If they were to admit that the company's failing, stockholders would immediately sell all their shares and employees would bail for other jobs.

Aren't government officials in the same position? If they felt the evidence led them to think we were headed for a depression that history would label "The Greater Depression," they couldn't speak out about it, lest everyone lose confidence in the economy and sell off all their stocks, thus ushering in an even worse recession.

2) Studies show that experts do a poor job of predicting the economy. Professor Philip Tetlock teaches at the University of California-Berkeley. He's an expert on top experts. For about 19 years (culminating in 2003), he studied 300 academics, economists, policymakers and journalists, to find out how they made their economic forecasts and chart how often they were right. According to Tetlock, "we found that our experts' predictions barely beat random guesses - the statistical equivalent of a dart-throwing chimp.... Ironically the more famous the expert, the less accurate his or her predictions tended to be."(1) Thus, odds are, that expert you heard forecasting the economy on the evening news, if you were to chart his past predictions, would probably have been wrong as often as he was right.

My guess as to their inability to conjure up an accurate picture of our economic future is that, in order to predict it, they'd have know many facts that nobody can possibly know. For example:
  • If our economy did better after government intervention following the last depression, how can we know for certain that the government intervention was the cause of the recovery.
  • Since no two economies are ever identical (in a sense, a visit to the past is a visit to a foreign country), how can we know that what worked then will work now?
  • The world's economies are more entertwined than ever before. How can we know what may happen in another country to either delay or speed our recovery?
Those are just three of the difficulties that I see springing up from a veritable Pandora's Box of economic possibilities.

So what do I do in the present economic climate? Despair?

No, I simply do what everyone should have been doing when most economists were predicting more cheery economic futures - don't believe them. Nobody knows. Realize that at any time, things could turn around and we'd be off to a prosperous decade, so that whoever bought up the cheap stocks would look brilliant in retrospect. Alternately realize that at any time, the economy could go to hell and we'll see a repeat of the Great Depression. Then again, things may continue as they are now for some time, neither getting better nor worse.

As author Kurt Vonnegut observed in his novel, Slapstick, "History is merely a list of surprises. It can only prepare us to be surprised again."

In other words, we don't know the future. Once we accept that, we can go about our plans with that in mind. That's why we major on the basics that work in any economy:
  • work hard. You never know when you might get sick or your services might no longer be required.
  • keep sharpening your skills so that you'll be the last one fired in a downturn and the first promoted in good times.
  • save all you can.
  • keep a large emergency fund on hand in case you lose a job for an extended time.
  • don't live beyond your means. Debt is always scary, good times or bad.
  • diversify your investments. Since the past isn't prologue, we can't know if the long-term gains of stocks or bonds or CD's or real estate will be the same as the past. Since we can't know which will do better, we diversify.
Disagree? Agree? Want to add to the discussion? Feel free to post your opinion below.

End Note

1) Eric Schurenberg, Why the Experts Missed the Crash, Money Magazine, February 18, 2009, 4:10 PM, ET.

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