Economists Are (Still) Clueless

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.

– John Maynard Keynes, A Tract on Monetary Reform

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

– John Kenneth Galbraith

Hitler must have been rather loosely educated, not having learned the lesson of Napoleon’s autumn advance on Moscow.

– Sir Winston Churchill

US GDP has been slowly ramping up, only to fall back and then try once more to bring us back to the ’90s. Stocks markets are volatile but seemingly moving higher in most of the developed world, except for Japan, where the current 20% drop comes hard on the heels of one of their frequent “end of the bear market forever” rallies of almost 90% – how many of those have we seen over the last 24 years? Europe is mostly in recession or Muddling Through with very slow growth. I continue to read from those who know China intimately that there is a real crisis brewing there. And over the last four weeks, I have highlighted how desperate the situation is in Japan.

The main obsession in the US seems to be whether and when the Fed may stop its current round of massive QE. Every hint of “tapering” spurs volatility in the markets. If you are a forex (foreign exchange) trader, you are left breathless at the recent moves, sometimes a whole order of magnitude (10 times) larger than average. Get used to it: currency wars are likely to be a feature of the landscape for the rest of this decade. (My friend Mohamed El-Erian, CEO of PIMCO, corrected me on stage recently, telling me the polite term du jour is “currency tensions.” And compared to what I think is coming, we really are just in the tension phase. Later we will get to skirmishes and then full-fledged currency combat.)

At the same time, there are some things to be sanguine about, at least in the US. Corporate profits are at all-time highs. The housing market is finally doing well in most parts of the country, adding jobs and boosting GDP. We continue to find more oil and gas seemingly everywhere we look. There are no political races this summer to spoil the mood since it’s too early for anyone to seriously run for president in 2016.

The economic forecasts of mainstream economists are quite positive, if not entirely optimistic, reflecting the current data. Should we not take heart from that? Alas, no. I have been working the last few months with my co-author of Endgame, Jonathan Tepper, on a longer paper in which we discuss the economic affairs of the world. One of our pet amusements is to research just how bad economists really are at forecasting. (Of course, we ourselves get branded with that economist label from time to time, although most serious economists would rather not be associated with us.)

This week we look at some of our recent musings on that topic, triggered by a letter from a very serious economist who took umbrage when I wrote disparagingly about economists and forecasting a couple months ago.

Now, let’s turn to that letter. Professor John Seater, a distinguished gentleman and economist from North Carolina State University, disagreed with my dismal view of economists and forecasting a couple of months back (“Assume a Perfect World“).

I actually do read the comments to my letters (I learn a lot), and I understood his irritation. I went to his website (I find an amazing number of my readers can be found writing in their own venues and often write intriguingly) and read some of his papers. I found myself really liking them, especially the one on the relationship between growth and regulation. I would highly recommend it to all the congressional staffers who read my letter (and I know there are a lot of you). And then show it to your bosses. Make them read it. (Warning: you may have to translate it for them. It is written in a subdialect of English called academic economics. I’m not perfectly fluent in it myself, but I can get most of it if I read slowly.)

Here’s a quick sample from the paper’s introduction:

We find that regulation added since 1949 has reduced the aggregate growth rate on average by about two percentage points over our sample period. As usual with the compound effect of growth rates, the accumulated effect of a moderate change in the growth rate leads to large effects on the level over time. In particular, our estimates indicate that annual output by 2005 is about 28 percent of what it would have been had regulation remained at its 1949 level.

As a professor of economics (macroeconomics at that), I find this article multiply irritating.

First, about forecasting. It is always easy to poke fun at economic forecasts, especially because they usually turn out to be wrong, often by a large margin. However, before laughing them off, think about what is being asked of those forecasts and the economists making them by considering the following analogy. I presume that most of you reading this own a car and have a license to drive it. The license certifies you to be minimally competent drivers, sort of the way a Ph.D. certifies an economist to have a minimal command of economics. Nonetheless, it is very easy to prove that you are all incompetent fools who know nothing about how a car works or how to drive it and thus to prove that drivers’ licenses are a big joke. Answer the following simple question: What will be the Mercator grid coordinates of your car exactly 2,190 hours from now (that’s three months), what direction will it be traveling, and how fast will it be going? You obviously don’t know. I have just proven that you are an incompetent driver and a fool deserving of ridicule because you claim to know the basics of how a car works and how it is to be used.

Asking an economist to predict where GDP (a far, far more complicated object than any automobile) will be in 3 months or a year and then ridiculing him for getting it wrong is exactly the same. An economist can tell you a lot about what makes GDP move around. Asking him to predict where GDP will be some months in the future, what direction it will be going, and how fast it will be going that way is very different. It is asking for an unconditional forecast without providing any information about what the driver (the American people and their government) wants to do, whether he will step on the brake or the accelerator, whether he will have the gears in forward or reverse, and so on. Of course, economists get it wrong, and often wildly so, just the way you can’t answer my question about your car.

Actually, professor, it is not the same. If I make a decision to do so, I can tell you with pretty good precision where my car will be in three months and at what speed it will be traveling. I can also give you a 98% probability of where I will be on Christmas Day, 2013.

But we do not ask economists to forecast the precise location of the economy a year hence. Just getting the direction (north or south?) right would be a good start.

The problem is that economists take these predictions so seriously, and so do politicians and investors. I think you might agree that the statistical probability that we will not have a recession in the US for the rest of the decade is quite low, yet not one budget projection assumes a slowdown, let alone a recession, which would absolutely devastate any budget as far as deficits are concerned. We act as if the business cycle has been repealed by an act of Congress.

© 2013 Mauldin Economics. All Rights Reserved. Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.