The vision thing

By Chris Giles

Published: November 25 2008 20:24 | Last updated: November 25 2008 20:24

http://www.ft.com/cms/s/0/1c1d5a9e-bb29-11dd-bc6c-0000779fd18c.html

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?” <st1:country-region w:st="on"><st1:place w:st="on">Britain</st1:place></st1:country-region>’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 <st1:placename w:st="on">Gresham</st1:placename> <st1:placetype w:st="on">College</st1:placetype>’s free public lectures in central <st1:city w:st="on"><st1:place w:st="on">London</st1:place></st1:city>, 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.

<st1:place w:st="on"><st1:city w:st="on">Giulio Tremonti</st1:city>, <st1:country-region w:st="on">Italy</st1:country-region></st1:place>’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 <st1:country-region w:st="on"><st1:place w:st="on">US</st1:place></st1:country-region> financial 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 <st1:place w:st="on">Europe</st1:place> have 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, <st1:place w:st="on">Europe</st1:place> is staring at the biggest recession since the early 1990s.

<st1:country-region w:st="on"><st1:place w:st="on">Britain</st1:place></st1:country-region>’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 <st1:country-region w:st="on"><st1:place w:st="on">Britain</st1:place></st1:country-region> is not there yet, and not even close”. As everyone now knows, <st1:country-region w:st="on"><st1:place w:st="on">Britain</st1:place></st1:country-region> was 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 <st1:chmetcnv tcsc="0" numbertype="1" negative="False" hasspace="True" sourcevalue="2005" unitname="a" w:st="on">2005 a</st1:chmetcnv> paper 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 <st1:place w:st="on"><st1:city w:st="on">Basel</st1:city>, <st1:country-region w:st="on">Switzerland</st1:country-region></st1:place>, was a persistent critic of lax monetary policy and the failure to stem credit expansion. Prof Rogoff also spotted the dangers of unsustainable global economic expansion 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 on Tuesday 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 <st1:country-region w:st="on">China</st1:country-region> and <st1:country-region w:st="on"><st1:place w:st="on">India</st1:place></st1:country-region>, 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 <st1:country-region w:st="on"><st1:place w:st="on">Japan</st1:place></st1:country-region> and 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.</o:smarttagtype></o:smarttagtype></o:smarttagtype></o:smarttagtype></o:smarttagtype></o:smarttagtype>