A Federal Reserve Report says Economists Fail at Forecasting – Really?

Robert J Samuelson had a syndicated column recently reporting on a U.S. Federal Reserve study of the accuracy of Macro-economic forecasting.  The study looked at forecasts of “important economic” indicators such as unemployment, interest rates, gross domestic product and compared the forecasts with the actual outcomes.  The study concluded that “considerable uncertainty surrounds all macroeconomic projections”. In fact, he said that the study authors found forecasting mistakes have worsened since the 2008 – 2009 financial crises.  The study he said compared forecasts from the Fed, the Congressional Budget Office, and the Survey of Professional economists.  The macroeconomic forecasts are no better than were the forecasts in the 1920’s before macroeconomic Keynesian theory.  Samuelson concluded that if macro-forcasts are flawed then we are destined to have periodic recessions.  The reason for the inaccuracy he concludes is that there are too many variables and people tend to think that the future will resemble the past.

I don’t disagree with anything he said, but I think there may be some things of importance to add.  Looking back on my experience, I think we could improve our forecasts.  Maybe not enough to avoid recessions, but maybe enough to avoid government policy adding to the problem.  Keynesian Economics was developed in the late 1930,s and seems to be a reflection on Roosevelt’s governmental policies during the great recession.  By the 1960’s we had decided that the government, which had not tried previously to control the national economy, not only could, but should try to control the health of the Economy.  The debate among the well-respected economist was between whether government fiscal policy or monetary policy was more important.  The monetary people put the most emphasis on the growth of the money supply and to a lesser extent on interest rates, while the fiscal folks looked at government spending and budget deficits.  On the fiscal side, the theory was to have a balanced budget during good times and run a deficit only as a stimulant during down times.  That made sense to me then, but we seem to be running a budget deficit now in good times or bad.  I have a problem with that.  On the monetary side, the emphasis was on monetary growth.  The problem there was that monetary growth did not seem to come from only the government printing money, but also from things like borrowing which was controlled by interest rates, was difficult to measure and possibly beyond government control.  But when I was in graduate business school in the early 1970’s the emphasis was on macroeconomic policy and forecasting. Adam Smith’s “invisible hand” was pretty much thought to be a thing of the past with very little importance to the overall economy. Not that microeconomics was wrong, it just wasn’t important.  In fact, my good friend who was also one of the PhD Economics professors told me when I mentioned that I might like to take a microeconomics course that micro was not important, only macro was important.

I decided later that maybe macro was important to him, because he got interviewed frequently by the media when government policy was involved, and that only involved macro variables.  In my graduate level economic forecasting class, Keynesian economic principles seem to assume that people would react the same way to the same government stimulus every time.  While working for a private company with operations in many different markets, I used micro and hardly ever used macroeconomics.  In between government forecasts of the entire economy and Adam Smith’s invisible hand is the subject of Industry Economics, which involves more micro theory than macro theory.  Working in a corporate planning group of a Fortune 100 multi-industry conglomerate we had several industry economists and only one macro-economist.  The industry economists were at the forefront of most of the planning studies and got questioned regularly by the organizational executives.  The macro guy was pretty much ignored by the corporate leadership.  (The media rarely talked to him either.)

I think Samuelson is right, part of the problem with macroeconomic forecast is that there are many variables.  But there may be more to it than that.  Keynesian Macro-economics, and the government’s ability to control the economy boils down to a very few variables.  The Fed today has as its major variable – interest rates.  Maybe to a lesser extent money supply.   The fiscal side is what the government spends money on – and not everything seems to have equal stimulus to the national economy – some things tend to be more job creating and some less. But the basic idea is that deficits are economically stimulating.  But with politics and different points of view on when and what to spend money on, the timing of most things that congress does is usually off – and timing is frequently a critical factor to keep the economy out of recession.  But the biggest problem is people and how they will react.  In physics in college I learned the “Ideal Gas Law” that is simple with few variables not unlike the government’s macro economic variables. In Engineering I learned that there is no “ideal gas” in the real world, and so there have to be corrective factors for each type of gas.  But with atoms and molecules, once the corrective factors are determined by experiment, the real gasses will react the same way every time.  That’s not true with people.  They tend to react more consistently to micro and industry economic factors.  But at the macro level, other things get in the way and make reactions inconsistent.

People have different needs and expectations depending on a lot of other variables.  How they react is dependant on a number of others factors that are not always consistent. .  Inanimate objects – atoms and molecules will react the same way over decades and centuries.  For example, as Samuelson said, anything that has been going in the same direction for several years, people expect to continue in the same pattern.  “Real estate went up for several decades, therefore it will continue.”  was part of the problem that led to the 2007 great recession.  It’s hard for me to believe how many of my friends saving for retirement got burned in the market by the tech bubble and decided to invest in real estate because “it will go up for ever”.  And the tech bubble or the end to the “new” economy was brought on at least in part, because a lot of people thought that companies would continue spending on tech the way they had been doing in the late 1990’s.  Demographics has something to do with a lot of this.  When the baby boomers were coming to maturity in the 1960’s , low-interest rates tended to be welcome because they made spending on things that people wanted and needed when they are coming out on their own, marring and having family’s. Now the Baby Boom generation is in retirement or saving for retirement and the low-interest rates penalize their retirement goals.  Micro – economics variables have much more consistency and stability than macro variables do.  The test period for a lot of government stimulation was in the 1960,s, but the population is not reacting the same way now as then for understandable reasons.  But what made this change worse was the market crash in 2001 (the end of the “new economy”?)  and the Fed dropped interest rates at a time when the housing markets were still going up and people thought they would forever.  The low-interest rates helped people buy real estate, and when the real estate bubble came apart in 2007, the Fed was accused of causing the problem by holding rates down too far for too long.  Rates since 2007 have been down 3 or 4 times as long with not much apparent effect.

The government organizations in the study – the Fed and the Congressional Budget Office seem to concentrate on the effects of changes in the government controlled variables –   Interest rates, Tax rates, government spending and deficits.  I don’t think they look at new government regulations that don’t affect government spending and tax rates.  The Fed dropped interest rates in 2007, which was a stimulus for more borrowing, but at about the same time we had new Financial Bank Regulations which means the banks did not have as much money to loan and had to be more stringent in who they lent it to.  Individuals might had lower interest rates if they could get loans.  But many who would like to have it could not get it.  This did not increase government spending, but it probably negated some of the effects of lower interest rates.  This is not in any of the macro-economic classes that I had in Grad School, but it is distinctly a factor in industry economics since it both raised their administrative costs and cut the loans they could make effecting their revenue.  Other regulations with good intentions no doubt raised costs and had other micro-economic consequences not accounted for in the forecasts.

But colleges and doctorate programs tend to emphasize macro-economics because we still believe that government can control the economy.  It also gets their economics departments more visibility with media interviews.  It’s one more of those beliefs that people need to change, and as Samuelson suggests, we should be prepared for more economic ups and downs.

 

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About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
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