Thursday, July 30, 2009

Can Experts Predict the Economy?

Many of us need to know our country's economic future, so that we can decide if it's a good time to start a business, expand a business, invest in the stock market, buy a home, etc. Thus, we listen to experts - those with academic credentials in economics, who teach economics in our universities, and who spend their days eagerly studying the minutia of economic indicators.

Thus, the media regularly reports the economic forecasts of these experts.

But how accurate are their predictions? Should we really base any decisions on their predictions?

There's actually a pretty easy way to judge their ability to predict the economy: see how well they've predicted it in the past. Fortunately, researchers have already done this. Here's an example:

"Can the Fed Predict the State of the Economy?"

A June 10, 2009 research paper with this title, written by three members of the Economics department of The George Washington University, studied the Fed's predictions for the years 1965-2001. Why study the Federal Reserve's predictions? First, it strives for objectivity. Secondly, its predictions are taken into account when our government makes policy decisions. Third, it has plenty of money and intellectual resources to gather the necessary facts.

This study examined the Fed's predictions in three areas: economic growth (as measured by the GNP), inflation, and unemployment.

It's conclusion?

"...the Fed knows the state of the economy for the current quarter, but cannot predict it one quarter ahead."

What's So Difficult about Predicting the Economy?

Now I'm no economist, but I'd venture that it's the same difficulty people have predicting the future of the stock market - the past isn't prologue. In other words, just because something happened in the past doesn't mean that it will happen in the future.

Let's imagine that the last six recessions were followed, within a year, by growing inflation. Can we assume that inflation will follow this recession within a year? No. Why? Because the past isn't prologue. The current recession may not have the same causes and cures as the last recession. A war could break out or end; a significant virus could shut down the internet. Any number of things could happen make the end of this recession differ from the last six recessions.

A Helpful Exercise

When a leading economic organization publishes its latest predictions, go back in history to see how their former predictions played out, especially prior to major economic shifts. Concerning the future of stocks, most forecasters fail. Examine their records. One popular media personality who recommends stocks, if you were to look at the results of his past predictions, well, you'd never listen to him again.

When someone asked Warren Buffett about the future of interest rates, he quipped, "There are only two people who know the future of interest rates. Both of them live in Switzerland...and they disagree with each other."

But Some Organizations Have Predicted the Economy Much Better than the Fed

True. But again, that's the past. Is their past performance predictive of their future performance? Only if we can know they succeeded by their skill rather than by luck. And how can we know this?

Studies of coin-flippers show that they come up with much longer strings of "heads" or "tails" than you'd imagine. Thus, what might appear as skill in a different context may simply be luck.

Imagine that hundreds of apes are released, one at a time, into a cage full of bananas. Written on each banana is a possible unemployment rate, from 1% to 20%. If this event were repeated for 10 years, many of the apes would have consistently chosen startlingly accurate predictions of the next year's unemployment rate. But nobody should conclude that the top apes were therefore more economically acute than the others. It was simply luck.

So, perhaps some organization out there can predict the economy pretty well. But how will we ever know for certain whether skill or luck is making them come out ahead?

The Outcome

We can know something about today's economy, but very little about the future. Thus, when making decisions, take into account both best-case scenarios and worst-case scenarios. If you're planning on buying a house, what if interest rates go up? What if they go down? What if you lose your job? What if you get a huge raise?

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."

It would appear that we must live life on earth knowing that the future is basically unknown. Plan accordingly.

Interesting Quotes

"I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters," joked Jon Faust, a former Federal Reserve Board economist who is now a professor of at Johns Hopkins University.

"When one does economic forecasting, you have to realize your forecast is going to be wrong," said Harvard economist James Stock.

"We are forecasting solid growth for 2008," top White House economist Edward Lazear told reporters. (Nov., 2007 prediction.)

"CBO forecasts that GDP will grow by 2.3 percent in real terms in calendar year 2007 but by 3.0 percent in 2008" (Report by Congressional Budget Office, which provides "objective, nonpartisan, and timely analyses to aid in economic and budgetary decisions on the wide array of programs covered by the federal budget."

Stock prices "should rise 10% to 12% next year (2008) amid calming credit markets and modest economic growth" (The UCLA Anderson Forecast is "one of the nation's premier quarterly barometers for California and the country's economic health.")


A recent (Sept. 6, '09) New York Times article asked, concerning the current, deep recession, How Did Economists Get It So Wrong?
They answered that, in part, economists had come to feel that the prevailing theory regarding macro-economics, supported by nerds with calculators, had failed to take into account all the variables that can happen in an economy.

"Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation."

"It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems."

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