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.")

Update

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."

Ramsey Reflections, Part 5

Continuing reflections on Dave Ramsey's Town Hall for Hope...

Takeaway #6: Three Things to Do If You're Losing Hope

1 - Get up! Take action! Get moving!

Don't wait for Congress or the President to rescue you. There's a great place for you to go when you're broke: to work! If you don't have a job, talk to everyone. Think creatively, be proactive.

2 - Don't participate in loser talk!

One survey found that your income will likely be within 10% of your closest friends. Some have "The Spirit of Eeyore" upon them, because they sit around moping with their loser friends.

Read "Who Moved My Cheese?" Our cheese has been moved. We've got to start thinking different. Be a reader. Keep learning.

3 - Learn to Give Again

Give extra during difficult times. If you don't have money, give of your time. Serve the homeless, serve soup at the union mission. Visit someone in a nursing home. The more you give hope, the more hope you'll receive.

Thanks, Dave, for an inspirational, fun-filled, hope-filled evening!

This post by J. Steve Miller, author of Enjoy Your Money: How to Make It, Save It, Invest It and Give It.

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.

Recent Interview: 5000 Years of Money Experience

In my ongoing interviews (100 people over 50 years of age), I spoke to a lady in L.A. and a man in Atlanta.

L.A. Lady: "Understand Your Investments"

She looked to be about 70 years (I never ask women their age), and she was distraught about her retirement. She normally goes to Mammoth Mountain every year to enjoy the wilderness, but she couldn't go this year. Due to the fall in the stock market, things were too tight.

I asked what she would advise the younger generation about the money and she responded, "Don't fall in love with your investments. I should have sold my stocks earlier this year, but my financial adviser kept telling me to 'stay on course.' As a result, I lost 2/3 of the value of my stock funds. When my son studied my situation, he told me I should sell my stocks to avoid losing more. After all, I could live several years on that money. So I sold."

She was so distraught at her huge loss that she didn't want to think about it. So I refrained from asking her any more questions. But here are my thoughts:

#1 - Since she was so close to retirement, why did she have such a large proportion of her retirement in stocks, seeing that she thought she would need the money soon? My mother's investments (she's well over 70) weren't really affected by the current crash, since she's not invested heavily in stocks.

#2 - She did what "the herd" always seems to do: sell low. When the stock market's this low, Warren Buffett's on a buying frenzy. In general, I don't want to be selling when Buffett's buying.

#3 - People simply must understand their investments. I feel really badly for her. People need to understand that stock funds can go down 2/3 and not bounce back for some time. If you don't want that kind of volatility, don't be in stocks.

Atlanta Man: Just Walk In and Ask People for Jobs

He's 72 years old and driving the shuttle from the Atlanta Airport. His advice to the younger generations:

#1 - Working is better than not working, even if it's at a low-paying job. You can't get ahead while you're not working. Sometimes he worked more than one job, just to see which one turned out better before dumping the worse job.

#2 - If you need a job, just walk up to people and ask them for a job, whether they say they're hiring or not. Employers seem to respect that kind of initiative. If they don't have a job, ask if they know anyone else who's hiring. (This advice jives with studies of those looking for jobs. Advertised job openings are flooded with applicants, making your odds on getting the job slim. Instead, decide what kind of job you want and approach those companies for a job, whether they are hiring or not. Maybe they just lost someone and you're the answer to their prayers. The last thing many companies want to do is to take time off from profitable work to start interviewing scores of people.)

Wise Investing Advice for Turbulent Times

These are scary times. I heard last Friday that my bank had shut its doors. Fortunately, another company had bought them out, so that I can still write checks, visit the ATM and receive automatic deposits from my companies. What if they'd not been bought out? How could I access my funds?

These are just a few of the questions people are asking these days. David Hultstrom is a financial adviser I respect. He gave me permission to reprint his recent newsletter below.

Subject: Financial Foundations October 2008 Newsletter, by David Hultstrom.

There seem to be a lot of questions out there about what is going on currently, so this month's newsletter will touch on a number of items and provide links to useful resources.

1) If you need a counterbalance to all the blaring headlines and breathless reporting about the current state of the financial markets, I highly recommend listening to the presentation at http://www.dfaus.com/library/videos/different/.

2) As you undoubtedly know, bank deposits are covered by FDIC insurance. If you would like specific information about how the coverage works, see http://www.fdic.gov/deposit/deposits/insuringdeposits/index.html.

3) Investment accounts are covered by SIPC insurance and information about that and other issues related to the failure of investment firms can be found at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/P116996.

4) There are a number of services that rate the safety of banks (see http://www.fdic.gov/bank/individual/bank/index.html), unfortunately most of them cost more than it is worth for a consumer who simply wants to know how their bank is doing. However, Bankrate.com does have a free search to see how your bank is rated at http://www.bankrate.com/brm/safesound/ss_home.asp.

5) The New York Times had a good interactive graphic that gave a sense of the size of the problems, see http://www.nytimes.com/interactive/2008/09/15/business/20080916-treemap-graphic.html and move your mouse over the listings. Note the data is a few weeks old now, which seems like an eternity in these fast-moving times. Also, this graphic gives a sense of the size of the Lehman bankruptcy http://www.investmentpostcards.com/2008/09/24/picture-du-jour-10-largest-us-bankruptcies/print/.

6) Based on monthly data since World War II, there have been 6 severe stock market downturns (declines over 20% in nominal terms). In these, the average decline has been about 1/3, and they have lasted an average of slightly over 3 years (in other words, the time from a peak through a 20% or more decline then on to a new high). In the worst of these (1973-74 and 2000-02), the market declines have been on the order of 45% and lasted 4-6 years until portfolios were back to their previous values. Currently, the U.S. stock market is down approximately 20% from its high almost a year ago. There is no way to know if it will go higher or lower from here. This is subtle but important. If there was a consensus that the market was going down further it would already be down to reflect that consensus. Conversely, if there was a consensus view that the market was headed higher, it would already be higher to reflect that expectation. There are only two ways to "win": 1) be smarter than the collective wisdom of everyone participating in the market, or 2) ignore short term fluctuations and remain with your target investment portfolio knowing that in the long run, you will be better off than the vast majority of folks who tried to time the market getting in and out. In this, as with many things, slow and steady wins the race. Occasionally, the market seems to get irrational and I think you may be able to profit from being less subject to the current hysteria (either positive or negative), this does not appear to me to be one of those times. I think the possible outcomes are much more uncertain than normal from this point and there is a significant chance of further deterioration and also a significant chance that the market could recover from this point. I don't know, and I know that I don't know (which might possibly make me smarter than the TV talking heads though less entertaining - I leave that for you to decide). Uncertainty and risk is why none of our clients have a 100% stock portfolio and none of our clients have 100% of the stocks they do own located solely in the U.S.

My tentative plan is to write next month about lessons that can be learned from both the technology bubble in the late 90's and the lending bubble we are still recovering from. Until then, if you need anything - even just to talk about what is going on - please feel free to contact us.

Note: Our clients are located around the country (and world), if you know someone we may be able to help, we would be happy to do so. While Financial Foundations is intended primarily for our clients, we are happy to expand our readership so feel free to pass this along. If you have received this from someone else in that manner and would prefer to get it directly from us each month, please let us know. Similarly, if for some reason you no longer wish to receive this (as unimaginable as that seems) simply let us know that as well.

Regards,

David E. Hultstrom
MBA, CFP, CFA, ChFC
Financial Architects, LLC
Financial Planning & Wealth Management
Address: 107 Weatherstone Drive, Suite 510
Woodstock, GA 30188
Phone: 770-517-8160
Fax: 770-517-8159
Toll Free: 888-Fin-Arch (888-346-2724)
E-mail: David@FinancialArchitectsLLC.com
Web Site: www.FinancialArchitectsLLC.com

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