Thursday, February 12, 2009

Can Economists Forecast?

The public thinks what economists do is forecast. It's not. I'll confess, I know nothing about forecasting.

Intrade tells us to expect unemployment over 9% by years end (earlier, if memory serves, they had it at 9.25%...)

Via Greg Mankiw, Ray Fair , an Macroeconomist at Yale, predicts unemployment will top out at 8.8%. The only problem is that he started with a baseline of 6.9% in quarter 4 of 2008 and has 7.8% at the end of quarter 1 in 2009. That's already a pretty big gap with reality, enough of a gap that I'm be tempted to throw the rest of his results in the trash. Assuming he's off on today's numbers by .5%, and that his errors don't increase, unemployment should top out at 9.3%. (Though given that his current error is so large, it doesn't inspire confidence.)

Meanwhile, the CBO predicts Dec. 2009 inflation at 9.0, and 8.5 as a low estimate with the Obama stimulus, and 7.7 as the "high estimate".

The trouble is, there's nothing stimulating the economy at the moment. The stock market is in free-fall. 600,000 jobs lost last month, and another million expected to be lost in the next few months means that consumer spending is continuing to fall. This, in turn, should mean more job losses. Best case scenario, the unemployment rate is at 8.1% six weeks from now (will probably be more like 8.3%). In the past few recessions, of course, the end of the recession comes well before employment starts to recover. So I don't get why anyone thinks we'll have such a strong recovery by the end of this year that the unemployment rate could fall. Again, best-case-scenario looks like we're in a position at the end of the year in which employment is month-on-month flat, but GDP has started to increase and confidence is restored. But that means the unemployment rate won't be any better than 8.1%, and that's if everything goes unbelievably well. 9% unemployment at year end seems to me to be overly optimistic, given the stimulus, and given that GDP starts to recover.

I'm curious, what do other people think?


  1. Ray Fair is an old-style macroeconometrician, his forecasts are based on one of those systems with tens or hundreds of simlutaneous equations. So if you believe in that kind of methodology, then you should have confidence in his forecasts (I'm kind of dubious). I don't know how the CBO does it, probably some sort of time-series regression based on past data - if you think this time is different, which I kind of do, then that's a reason to disbelieve them. My wild-ass guess is that we'll see the "L-shaped" recession, with unemployment hitting 10% and muddling along for a while.

  2. Good post Thor, I come from a background in the professional dismal science as an economist/policy analyst, and I personally think the way it is held as a high science among the teachers and many practitioners can only be called one thing: bullshit. It is decidedly inexact (just about every 'law' or theory is broken, yet still stands even though it does more harm than good), yet people claim to have an ability to use its tools to create coherent logics that are subsequently usable in the real world.

    In policy, it's a guess based on past data and what we 'think' will happen. In business, the numbers are backed into, and only in academia do they 'know' the answer. That's what a fancy piece of paper buys many 'economists,' the certitude to have the right answers because you understand how to run some equations.

    Now, the econometricians are better in that they seek out wide ranges of statistical information that may feed into their ability to sniff out a reality. Their wide range of knowledge, and seeking nature helps them find some rules to grasp on to. Yet, they are limited by factors of sampling error (the data set is never big enough) and that the world decidedly changes over time (people adapt). They are better served coming up with models, knowing their strengths and weaknesses, and dealing with the statistical reality without the thorough hubris that is attached to it.

    What the whole pseudo-science comes down to is developing a rigorous (in that it is detailed and complicated, not exact) methodology that may be used to predict the future, or establish laws of human behavior. Yet, the techniques are so distant from science and the factors going in so complicated that attempting to assume we 'understand' the whole framework is undoubtedly a misconception.

    Instead, we are dealing with systems that are - as George Soros points out from the investing and practicing/real economist crowd - necessarily affected by those studying it (this he sums up in his concept of reflexivity). The attempted realm of study is not human action, it is human interaction, a much more complex endeavor.

    If we seek to understand people, there are great treatises that have served as guidebooks for those who seek to do, unluckily I don't think I could name very many in the last century that would strike me as 'necessary' and 'original' reading. Trying to get a better grasp of the last 100 years would be better understood by first reading the classics to understand base drivers of human action (the Plato's, Machiavelli's, Sun Tzu's, Hobbes', Metternich's, etc.). If you believe that there is a human nature, or human condition, then these books are helpful and accurate. In my opinion, one comes with the other. In a similar flip side, understanding belief is an important piece of the human condition as well, so in that regard, the religious treatises (to understand how tangential momentum matters so greatly, and how we seek answers, we don't know them, but we seek some form of peace). Finally, developing skills that are used in modern professions are better to know to ground yourself in today. These would income things such as accounting, banking, statistical risk management (to understand how it is flawed), policy analysis (to understand how answers have round edges), engineering, and politics (for you really never know how little we 'know' about how the game is played until you've spent time inside). I think this is part of the two-edged sword of individualism, it frees one, yet it helps one realize that those who it is meant to socialize with (those around them, we are simply people), also may impede ones quest for survival/advancement/happiness.

    In my mind, economics is nothing more than a school of philosophy, with a whole lot more certainty. It's tools are often more damaging than helpful.

    That being said, I'll put my coin on the table (I already have, one of my largest bets is for the British pound to continue to significantly devalue, on top of a previous bet doing so). I'll preface my predictions in that they are more drawn out from the alignment of so many of the processes aligning the professional practices in which most people are employed are now governed by a central set of signals (money and debt, the local environmental factors have been minimized, while the constructivist human element has been expanded greatly), and by recent standards, they are all out of whack. Think about it this way, how will the incomes of the koi (the bushmen in Southern Africa) be affected by the financial crisis?

    Now the rest of us believe in, and live within a heavily human constructed/reinforced environment, which we have a history of failing to manage, with crises arising more than sporadically. Financial crises and the breakdown of political networks (wars) are the breakdowns from the head of the massive people management systems where one person can sign a bill, or check that takes the wages (reward for individual behavior) of millions of people and then places it in different hands. Not that I don't believe that this is necessarily unjust, it just is. Humans often believe, or hope to believe that they have an answer for the world, rather than just struggling within their locally believed in, created and understood environment, often in the struggle to make peace with their world, they interpret it as 'the world,' as far the imagination can be stretched and understood. So as long as we believe that we have things under control, and subsequently those methods we use to create and recreate our environment (our professions) don't hold up to what they have to do to be useful, then we will be forced to forge new relationships, and deal with a new local and a new personal quest to make peace with the 'world.' We don't know what's going on, we're just getting better at dealing with each other and coming up with rules that we can accept, usually temporarily at best. When so many of those professions fail simultaneously, it does not bode well.

    So, with reckless abandon, I'll say unemployment will definitely be above 10% by the middle of 2010.