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Wednesday, November 26, 2008

Why Did Forecasters Missed the Crisis?

Dean Baker will wonder why he was left off this list:

The vision thing, by Chris Giles, Commentary, Financial Times: 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. ...

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. ... Second, as Stephen King, chief economist of HSBC, says: “Almost all economic models assume that the financial system ‘works’.” ...

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...

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..., 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 ... 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. ...

Mention must ... 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 ... 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 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... 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 ... 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. ...

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...

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 ... with exaggerated speed and to an exaggerated degree. ...

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.

    Posted by on Wednesday, November 26, 2008 at 12:42 PM in Economics, Housing | Permalink  TrackBack (0)  Comments (47)

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