God is a Capitalist

Friday, July 4, 2014

Forecasting Failure

The latest revision of GDP for the first quarter of this year caught most economists by surprise. A decline of 2.9% is the worst since the latest recession. Surprising most economists shouldn’t surprise anyone. The Laissez Faire newsletter alerted me to studies by the IMF economists Hites Ahir and Prakash Loungani on the abilities of private and public sector economists to forecast recessions. In short, their records are almost perfect, failure that is.

The photo of the Queen with the comment “Why did no one see this coming?” comes from a presentation at George Washington University on forecasting by the two economists. In a second photo, a London School of Economics representative responds, “Ma’am, to see this one coming would have ruined our perfect record of failure to see it coming.”

The comedy is based on an actual visit by the Queen to the LSE in 2008 in which she asked the top economists in the nation her question. The economists told her they would get back to her. Later they wrote a letter to the Queen in which they noted that the best mainstream economic theory claims that recessions are random events so they had succeeded in predicting that no one can predict them.

An IMF paper, “IMF Forecasts Process, Quality, and Country Perspectives” prepared by the IMF’s Independent Evaluation Office concluded,
Particularly significant overpredictions  of GDP growth tended to occur during regional or global recessions, as well as during crises in individual countries. Except for these episodes, the forecasts did not show substantial positive or negative biases. These findings apply to shortterm as well as medium-term forecasts. 
The accuracy of IMF short-term forecasts was comparable to that of private forecasts.
Well, Austrian economists can’t gloat over the fact that mainstream economists can’t predict recessions; neither can Austrian economists. Here is the difference: Austrian economists think in terms of cycles and understand the cause of recessions – counterfeiting by central banks. So Austrian economists think cyclically. We expect recessions and have a handful of omens we watch, such as record profits (Financial Bull Riding) or Spitznagel’s (The Dao of Investing) MS Index. By expecting recessions every four to five years, investors can get out of the market long before recessions hit and cause stock market collapses such as happened in 2000 and 2008.

Mainstream economists see recessions as unpredictable random events. They assume economies are in equilibrium most of the time and would stay in equilibrium if random shocks didn’t send them spinning out of control. Mainstream economists are happy with their models because they are accurate when forecasting GDP most of the time. Investors should keep in mind that in many of the models used for predicting recessions the chief leading indicators are the money supply and the stock market. So investors should never use mainstream economic forecasts of recessions for investment advice because those economists are using collapses in the stock market to tell them a recession is headed their way.

Of course mainstream forecasts of GDP will be fairly accurate most of the time because expansions typically last four to five times as long as recessions. For example, in a five year cycle the expansion will usually take up four years and the recession one. So in a time series set of data covering say 20 years, economies will be expanding most of the time and the method for modeling the data will fit to those years instead of the rare recessions. That will be especially true because of the long expansions from 1982 to 1990 and 1992 to 2000, the “Great Moderation.”

Forecasters could improve their chances of forecasting recessions if they randomly selected the expansion years so that the number of years of expansions equaled the number of years of recessions. That would improve a model’s ability to predict recessions but make forecasts of expansion years less accurate.
The models only fail to see downturns in GDP that indicate recessions.  But most investors don’t need to know that most of the time the economy grows. They need to know how to protect their nest eggs from the nasty collapses, the point where mainstream models consistently fail. To paraphrase Keynes, telling us the ocean will be calm after the storm doesn’t help.

Mainstream economists see sunny investing weather for the foreseeable future. They respond as the great economist Washington Irving responded to calm seas as reported in his essay “The Mississippi Bubble”:
In the course of a voyage from England, I once fell in with a convoy of merchant ships bound for the West Indies. The weather was uncommonly bland; and the ships vied with each other in spreading sail to catch a light, favoring breeze, until their hulls were almost hidden beneath a cloud of canvas. The breeze went down with the sun, and his last yellow rays shone upon a thousand sails, idly flapping against the masts.
I exulted in the beauty of the scene, and augured a prosperous voyage; but the veteran master of the ship shook his head, and pronounced this halcyon calm a "weather-breeder." And so it proved. A storm burst forth in the night; the sea roared and raged; and when the day broke, I beheld the late gallant convoy scattered in every direction; some dismasted, others scudding under bare poles, and many firing signals of distress.
Like the Biblical warning that when everyone cries “Peace! Peace!” then sudden destruction falls upon them, so good investors should interpret mainstream economic forecasts of peace and calm seas as warnings of approaching disaster.

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