The economic forecasters got it wrong – looking at the specifics

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Economic forecasters got it wrong over the last year, but it is important to focus on what specifically was missed and what are the implications of those misses for the future. There have been some clear down trends in asset markets over the last few months because forecasters have been consistently less negative than the actual data has shown. The forecasts were wrong not only about direction and size at the beginning of the year, but consistently got it wrong throughout 2008. In 2008, the future was truly unknowable once we go out a few months or when faced with a unique event that has not had a precedent. As Karl Popper stated,” to predict the creation of the wheel is to invent it.”

This year’s forecasting problem was fourfold. One, forecasters missed the liquidity and banking crisis of 2008 based on faulty assumptions concerning the housing market. Two, the forecasters were off on predicting the commodity price shock and its disruptive impact. Three, the forecasters got the money demand, wealth effect, and consumer confidence wrong. Four, forecasters were wrong the asset quality problems because of poor private information on firm asset.

The banking and liquidity crisis problem was hard to forecast for the simple reason that there have not been that many banking crisis to look at for comparison. The Scandi crisis is the best comparison from the 1990’s but in that case, the financial failures were relatively self-contained. The Japanese “lost decade” was never used as a model for what could be the problem in the US. We are now thinking otherwise. The premise of the Japanese crisis was that government was unable to effectively deal with the bursting of their real estate bubble. There has been an over optimism that the Fed and Treasury would get this problem solved. Look at the fact that the stock market hit highs after the initial crisis in August 2007. It was the unraveling of the GSE’s in July that tipped the scales against a contained crisis.

The extreme commodity price shock from high demand was not predicted. The start of the credit crisis in 2007 was at much lower commodity prices. The run-up in agriculture and energy prices continued unabated through the first half of 2008 as everyone thought rising prices and shortages would be the problem. This shock started to change consumer confidence and investor behavior. Forecasters did not find a strong link between rising commodity prices and falling financial asset prices. Economists never saw the strong run-up in prices so they were consistently behind in predicting the impact on consumers.

Some of the basic linkages in the economy were not predicted to change. First and foremost, there was never the prediction that money demand would slow so strongly. The falling velocity of money caused by banks not lending shut down the financial oil in the economic engines of many countries. Economist will have to rethink how they look at money demand given this extreme.

Similarly, the falling consumer confidence from the financial fall-out was not adequately predicted. The link between Wall Street and Main Street is tighter than what many have imagined and should be the main reason for bailing out Wall Street. What happens in the canyons of lower Manhattan matters to the person at the suburban mall.

Finally, the elusive wealth effect is real. Perhaps the link has not really changed but the size of the decline has caused the wealth effect threshold to be crossed. You hit the housing assets and financial assets of most Americans and they will react. Slower housing may be one thing but you mess with retirement funds and consumer behavior changes.

Finally, the information gap during this crisis has been huge. This caused a significant error in forecasting the hit to asset values. The information shortfall started with financial firms which could not provide a good idea on the valuation of their assets and continues with policy-makers who could not send clear signals on what are the policies that will be followed in a crisis. The focus has been on the regulatory environment when the key to a well-functioning economy is the information gap. Big gaps of knowledge and uncertainty will cause conservative behavior, the flight to cash.

So how do we solve these problems? The banking crisis is moving forward under the growing perception that we are faced with a Japanese style problem. We have now seen a more explicit move to quantitative easing. The commodity shock forecast problem has not been solved as much as reversed. The discussion of deflation may be premature but the tax of higher energy cost has been eliminated. The money demand confidence problem is now realized though we have not found an effective means of making banks lend. The information and uncertainty gap is still present and needs to be closed. Overall we have made some headway to identifying and solving the forecasting problems and we should see better estimates and some pullback from the economic freefall.