The vision thing: How economists
failed to spot the catastrophe
By Chris Giles
Published: November 25
200820:24http://www.ft.com/cms/s/0/1c1d5a9e-bb29-11dd-bc6c-0000779fd18c.html?nclick_check=1
It has been a bad year for economic
forecasters. So bad that royalty wants to know what went wrong. “Why did no one
see it coming?” Britain’s Queen Elizabeth asked during a visit to
the London School of Economics this month.
Her Majesty’s question has sparked a series
of ludicrous claims about the prescience of individual forecasters.
“Although bankers with their fancy MBAs
appear to have been dumbfounded by the financial crisis, regular attendees to
GreshamCollege’s free public lectures in central London, were not,” maintained
one press release
this month, citing a talk given in November 2002 by Avinash Persaud. But the
lecture is as disappointing as the claims are inflated. “Despite record
corporate bankruptcies, weak economies and a market meltdown, banks are
generally safe” was Prof Persaud’s conclusion.
Giulio Tremonti, Italy’s finance minister, raised the predictive
bar last week when he said Pope Benedict XVI was the first to foresee the
crisis. A 1985 paper showed, according to Mr Tremonti, “the
prediction that an undisciplined economy would collapse by its own rules”.
Much closer to the truth was the more mundane assessment by Charlie Bean, the
Bank of England’s deputy
governor, who noted that elements of the global economy had troubled lots of
economists and policymakers for a long time. “We knew they were unsustainable
and worried that the unwinding might be disorderly, though I don’t think anyone
could have guessed the course that events would actually take,” he said.
There is no doubt that the credit crisis,
which has morphed into recession across advanced economies, leaves most
economic forecasters with ample egg on their studious faces. But policymakers,
too, have reasons to cringe.
In his Senate nomination hearing of 2005, Ben Bernanke, the Federal Reserve
chairman, said the USfinancial system had already benefited from
a series of crises that had reinforced its ability to cope with difficult
times. “The depths, the liquidity, the flexibility of the financial markets has
increased greatly,” he said.
Policymakers in Europehave had equal problems in foreseeing
events. Jean-Claude Trichet, European Central Bank president, told four
newspapers in mid-July: “Our baseline scenario is
that we will have a trough in the profile of growth in the euro area in the
second and third quarters of this year and, following this, a progressive
return to ongoing moderate growth.” Instead, Europeis staring at the biggest
recession since
the early 1990s.
Britain’s nasty recession was not foreseen by Mervyn King, Bank of England
governor. In May, he insisted:
“It’s quite possible that at some point we may get an odd quarter or two of
negative growth. But recession is not the central projection at all.”
International organisations, the great new
hope of world leaders to provide an early warning of future problems, are just
as fallible. The International Monetary Fund’s spring 2007 forecast gushed
at the success of the world economy. “Overall risks to the outlook seem less
threatening than six months ago,” its World Economic Outlook purred, in prose
overseen by Simon Johnson, its then chief economist.
Among independent economists the record has
been just as bad. The forecasts for growth compiled every month by Consensus
Economics show a persistent move towards pessimism as Wall Street and City
professionals catch up with events.
Even permanent bears did not see the full
bursting of the credit bubble linked with the commodity boom. Nouriel Roubini,
the
global “Dr Doom” who got much of the crisis right, has also persistently
revised his forecasts lower as the credit crunch has bitten harder.
The media cannot claim better foresight.
While some commentators have found their predictions of crisis realised, none
got
the entire story right and many were lucky, having predicted 10 of the last two
crises that eventually materialised. But others’ luck does not diminish the
embarrassment I feel when I read my own assessment from July that recession
“might happen,
but Britainis not there yet, and not even close”. As
everyone now knows, Britainwas there, even at the time.
Though there is great entertainment in
looking back at the silly things economists have said, more is to be gained by
examining the particular failings that contributed to forecasters’ general
inability to warn of the current mess.
First is the unforeseen, but now evident,
fragility of the global economy in the face of a systemic banking collapse. Jim
O’Neill, chief economist of Goldman Sachs, says the failure of Lehman Brothers
was “a game changer”, before which his forecasts “were panning out OK” and
after which “we have been scrambling to keep up”.
Second, as Stephen King, chief economist of
HSBC, says: “Almost all economic models assume that the financial system
‘works’.” Economists in general did not foresee how the looser monetary policy
of the early part of the decade could lead to an unprecedented credit
expansion.
Third was the deep squeeze on household and
corporate incomes from the commodity boom of the first half of 2008, which
almost no one predicted. This weakened the non-financial sector before banks
had any chance to repair the damage from the subprime crisis and was a crucial
element of the disaster that unfurled this autumn.
Fourth, most economic models suggest the
demand for money will be stable, but banks and households have now begun to
hoard cash. This threatens to make monetary policy ineffective as a tool for
economic recovery, something that is not generally factored into forecasting
models.
Fifth is an over-reliance on the output gap
– the difference between the level of output and an estimate of what is
sustainable – in forecasting. That allowed policymakers to believe everything
was fine in the economy, because inflation was under control and growth was not
excessive.
Sixth is the natural tendency to seek
rationales for events as they unfold, rather than question whether they are
sustainable. Kenneth Rogoff, a Harvard professor who is also a former IMF chief
economist, thinks the tendency to look on the bright side is particularly
prevalent on Wall Street, where “it is difficult to make a living as a
mega-bear”, he says.
Academics and the Fed also fell into the
trap of rationalising unsustainable features of the global economy. In 2005
apaper by Ricardo Hausmann and Federico Sturzenegger of
Harvard caused excitement about the possibility that financial “dark matter”
would prevent a big bang in the world economy. The failure to believe in this
dark stuff, the authors concluded, made “analysts predict crises that, for good
reason, remain elusive”.
Mention must also be given to the notable
voices of doom, who got important bits of the puzzle correct even if the timing
or other details eluded them. Prof Roubini, who now runs the consultancy RGE
Monitor, wrote a paper with Brad Setser in August 2004 predicting that the
world’s trade imbalances were unsustainable and likely to “crack the system in
the next three to four years”. He has been prescient in understanding the links
between financial markets and the real economy.
William White, the former chief economist of
the Bank for International Settlements, the
central bankers’ bank in Basel, Switzerland, was a persistent critic of lax
monetary
policy and the failure to stem credit expansion. Prof Rogoff also spotted the
dangers of unsustainable global economicexpansion in a 2004 paper with Maurice
Obstfeld. In more
recent work with Carmen Reinhart he has highlighted how policymakers
fell into the “this time it’s different” trap that dates back to England’s
14th-century default.
Prof Persaud has made an honest living for
many years warning about the fallibility of value-at-risk models and the
tendency for them to encourage herd behaviour. And in the FT’s new year survey
of
economists for 2008, Wynne Godley of Cambridge university, also a permanent
bear, said: “I think the seizing up of financial markets may well result in a
collapse in lending in the US to the non-financial sector so large that it
causes a recession deeper and more stubborn than any other for decades – and
deeper than anyone else is expecting.” Quite.
Policymakers, too, have been far from
consistently wrong. Mr Trichet dines out on stories of how he predicted the
crisis and cites a Financial Times article as evidence that the warnings were
not just the sort of throwaway remarks about risk that central bankers always
give. Mr King warned for years about the risks evident in the global economy
and the IMF repeatedly warned about the unsustainable level of house prices.
Willem Buiter, whose blog on FT.com was
praised yesterday in parliament by the Bank of England governor, warns not to
be too impressed by some forecasts that have turned out to be true, because
they were lucky, not wise. “Hindsight is useless,” Prof Buiter insists. “One
has to look at the information available at the time and the arguments used at
the time.”
That is certainly valid and should form the
basis of any judgment of forecasts or policy decisions taken. But it is also
incumbent on the consumers of economic forecasts to be aware of what economic
models can and cannot do. They should focus on the risks rather than purely the
central forecasts.
Goldman’s Mr O’Neill says private sector
economists should try harder to under-promise and over-deliver. Despite all the
talent and the most sophisticated models, they “didn’t and couldn’t have
predicted the Lehman ‘event’.”
If only society had listened to the younger
Cardinal Ratzinger more than 20 years ago – before, of course, it was reasonable
to forecast he would be the next Pope.
PREDICTIVE MODELS:
BLOWN OFF COURSE BY BUTTERFLIES
In the 1980s, it seemed that computers held
the key to economic forecasting, writes John Kay.
With large models and sufficient processing power, predictions would become
more and more accurate.
This dream did not last long. We now
understand that economies are complex, dynamic, non-linear systems in which
small differences to initial conditions can make large differences to final
outcomes – the proverbial flapping of a butterfly’s wings that causes a
hurricane.
So economic crystal ball-gazing remains
unscientific. The trend is the forecaster’s friend. Extrapolation assumes that
the future will be like the past, only more so. We project current
preoccupations
– the rise of Chinaand India, global terror, climate change – with
exaggerated speed and to an exaggerated degree.
We forget that our preoccupations change.
The people who worry about these issues today would 20 years ago have worried
about the coming economic hegemony of Japanand the cold war. These issues were
resolved in ways that few predicted.
It is a safe prediction – and the only one I
shall make – that the topics that grab our attention 20 years from now will
differ from those that consume us today and, if anyone has guessed what they
are, it is only by accident. The future is unknowable. As Karl Popper observed,
to predict the creation of the wheel is to invent it. To anticipate a new
political force or economic theory, or even a new product, is to take the main
step in bringing it into being.
If extrapolation is the forecaster’s friend,
mean reversion is the forecaster’s crutch. Much of the time, you can predict
that next year’s figure will be somewhere between this year’s level and the
long-run average. But mean reversion never anticipates anything out of the
ordinary. Every few years, out-of-the-ordinary things happen. They just have.
Still, you might think there would be large
rewards for those who succeed in anticipating these events. You would be wrong.
People who worried before 2000 that the “new economy” was a bubble, or warned
of the terrorist threat before September 11 2001, or saw that credit expansion
was out of
control in 2006, were not popular. They were killjoys.
Nor were they popular after these events. If
these people had been right, then others had been blind or negligent, and the
latter preferred to represent themselves as victims of unforeseeable events. As
John Maynard Keynes observed, it is usually better to be conventionally wrong
than unconventionally right.
Copyright The
Financial Times Limited 2008
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