Why economists cannot forecast recessions

 

Alasdair Macleod

 

The purpose of this article is to draw the widest attention to the chronic inability of the economic establishment to forecast recessions. Next time you hear an economist make a prediction on mainstream media, your default assumption should be he or she is simply wrong.

 

Why do I allege this? An IMF economist, Prakash Loungani, did some interesting research in 2000 about the accuracy of economists’ forecasts. Using data taken from a publication called Consensus Forecasts (published by Consensus Economics), which is widely used as a source of independent estimates of economic growth by individual governments, Loungani found that of the 60 recessions recorded since 1989 in the 63 countries sampled, only two were forecast in April the year before and two-thirds remained undetected in the April of the year they occurred. Furthermore, analysts’ forecasts emanating from both private and public sector economists were little different, and had a strong bias towards optimism.[i]

 

Loungani was recently interviewed for a BBC programme, updating his original paper. In that interview, he claimed that over three decades, of the 150 recessions recorded only two had been forecast, implying that since the turn of the century no recessions had been forecast at all. [ii] The failure rate has increased to 100%, not decreased, as might be expected from economic models that are updated in the light of experience. Unsurprisingly, Loungani admitted he was unpopular amongst his peers for disclosing their complete and utter failure.

 

It is a timely reminder that the Queen’s apposite question in late 2008, about the failure of economists to predict the great financial crisis, hit the nail on the head. In an example of unintended humour, a consensus of macroeconomists, constituting the economic establishment, then considered the matter and over a year later wrote a three-page letter to Her Majesty, explaining why it was not their fault, and importantly, not the fault of their method. They summarised it as follows:

 

“…. the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”[iii]

 

In other words, understanding risk is a financial function conducted in markets, not a function of economic prediction. Yet, despite the failure of the academic community to add any predictive value to our lives, they are still relied upon by governments as the basis for managing the economy and to forecast tax revenues.

 

Forecasts are central to economic management. Unless you can predict or measure the outcome, economic policy has no justification and should not be embarked upon. The continuing, total failure of the macroeconomic establishment to quantify the effects of the policies they recommend would not be permitted in a rational world. Their version of the dismal science offers no benefit to humanity.

 

IMF and Brexit

 

Despite the evidence from an IMF economist of their own total incompetence, the IMF has not acknowledged the futility of forecasting economic outcomes. It also seems that when they try to forecast a recession, instead of mistakenly forecasting economic growth at rates that turn out to be too optimistic, they get that wrong as well. They warned, along with the Bank of England and the Treasury, that a vote for Brexit would be an economic disaster for the UK. Instead, the economy has prospered, with unemployment falling to the lowest in forty years. They warned that industrial investment would collapse. Instead, it continued at an accelerated pace, once the uncertainty caused by the establishment’s negativism had ended with the referendum. They warned that the City would suffer badly, frozen out of EU markets. The City continues to prosper. The one time the establishment, including the IMF, the UK Treasury and the Bank of England, decided to forecast a recession as opposed to continued growth, it got it completely wrong.

 

Only last week, the IMF decided to have another try, with an update to its World Economic Outlook, issued 19th July. Here is an example of the IMF’s suppositions:

 

“The outcome of the U.K. vote, which surprised global financial markets, implies the materialization of an important downside risk for the world economy. As a result, the global outlook for 2016-17 has worsened, despite the better-than-expected performance in early 2016” [iv]

 

So, having admitted it got its forecast for the UK completely wrong, now Brexit is an excuse for the IMF’s downward revision of previously too optimistic expectations. It seems Brexit is so much against the establishment play-book, they cannot leave it alone. However, it is hard to resist the temptation to conclude that as a contrary indicator, the WEO is positive news for the British and global economies.

 

There is a simple explanation for this unmitigated forecasting failure, overlooked by the planners. While the distortions and unintended consequences of monetary and economic interventions accumulate and occasionally trigger a crisis, the rest of the time people just get on with their lives. They do not sit on their hands and await instructions from government economists as to how they should behave. Consequently, state interventions have limited, if unpredictable results.

 

Why economic forecasting will never work

 

The unblemished record of bad advice from mainstream economists is truly staggering, yet collectively we still believe in it. Part of the problem is systemic, with any dissenter from the broad consensus asking for trouble. Far better, surely, for a career economist to keep his head down and not gain a reputation amongst his peers as a maverick. That explains, and justifies, group-thinking conformity. But it still doesn’t fully explain the almost perfect non-correlation between economic forecasts and outcomes.

 

The root of the problem lies in the evolution of macroeconomic theory since the First World War, and more particularly since the Second. Starting with the banking system, economists were increasingly encouraged to go against classical free-market economics, and invent a positive role for the state and its agencies. Following the First World War, the US Federal Reserve Board became responsible for overseeing the expansion of money supply, including an attempt to establish a discount bill market to rival that of London, fuelling credit expansion even further.

 

The Fed, under the chairmanship of Benjamin Strong, assisted the Bank of England to remain on the gold standard. The monetary and political roles of the Fed were no longer exclusively domestic. They became international, and contributed to the monetary excesses of the Roaring Twenties on a global scale. Then President Hoover, followed by President Roosevelt, respectively promoted direct state intervention in the US economy after Wall Street crashed, in defiance of free markets.

 

There is a credible argument, beyond the scope of this article, that if free markets had been left to sort out the economic mess that resulted from the Fed’s excessive monetary stimulation and the expansion of bank credit in the 1920s, the depression would have been over in a year or two. Instead, the politicians constantly interfered, trying to protect jobs and keep bad businesses afloat. They stifled free trade, through the Smoot-Hawley Tariff Act. The results were disastrous and prolonged the depression. But despite the clear evidence to the contrary, leading economists such as J M Keynes persisted with their belief that state intervention was superior to free markets.

 

There are many reasons this is all wrong, but the one that is central to the failure of forecasting today is the erroneous assumption that GDP measures economic consumption. It only measures the monetary value of the consumption included in a selective index, which is not the same thing. Furthermore, it confuses an accounting identity for a dynamic economy, where tomorrow’s demand always advances, so is different from today’s.

 

Debasing money creates a statistical appearance of economic growth, dependent upon the lag between the creation of money and its effect on prices recorded in a selective consumer price index. And because the rise in prices necessarily lags the introduction of the new money that causes them to rise, GDP adjusted by the selective price index will normally be a positive number, so long as the quantity of money and credit continues to expand. However, the rate at which this new money increases the price index is itself unpredictable.

 

The two common exceptions are when the new money is applied to items not in the index (notably assets and other non-consumption goods), and when the accumulation of debt leads to a credit crisis and the destruction of credit.

 

It really does not require the brains of an Einstein to understand this. Once this point is firmly grasped, it becomes clear that GDP is no more than an incomplete historic accounting identity, telling us nothing about the future economy. Yet economists are blind to the evidence. The questions raised by the failure of modern macroeconomics to quantify policy outcomes undermine the logic of intervention itself. Overturn the logic, and you can easily demonstrate that the state-controlled monetary system is itself responsible for periodic recessions, slumps and crashes.

 

That is the cause of our economic ills, not free markets. Central banks and fractional reserve banking should be banished, and replaced with sound money. Think of all the unemployed economists, learning they have wasted their lives, and you can understand why they will hold onto their delusions to the bitter end.

 

A forecast you can rely on

 

The economy, or at least that part of it which is based on the private sector, is dynamic and progresses. To think of it as a static unchanging entity, which is the underlying assumption behind today’s macroeconomic analysis, is simply wrong. Its progress can neither be measured nor predicted, and it is progress that matters.

 

What can be more easily predicted are the economic consequences of a state pursuing its objectives. Governments in the major European and American economies have reached the limit of rising taxes to pay for their expenditure. Instead, they now rely on borrowing, coupled with monetary inflation to finance their excess spending.

 

The deterioration in government finances, in what we can accurately label the welfare states, is accelerating and already out of control. Unfavourable demographics with aging populations are adding rapidly to pension and healthcare costs. We therefore know that government spending is continuing to escalate at an unsustainable rate, though we may have different opinions on the net present value of those future liabilities. The consequence is the private sector is being increasingly suppressed in its ability to accumulate the wealth required to support state spending.

 

There is also the legacy of government debt, whose cost has risen as the quantity of debt has increased. The immense encumbrance of this debt has only been temporarily offset by central banks pursuing ultra-low interest rate policies. Only a modest increase in borrowing rates will threaten to destabilise government finances, so great has this burden become. And interest rates are bound to increase in time.

 

Interest rates will increase, partly because they can go no lower, and partly because we are at the stage, in a coordinated global cycle of credit expansion, that will in time threaten a significant fall in the purchasing power of fiat currencies. And as money’s purchasing power declines, prices will rise, forcing central banks to raise interest rates. Despite the widespread reluctance to understand it is the expansion of credit that is the problem, this is a prediction that can be made with complete confidence.

 

We can also predict the scale of different governments demands on their private sectors. And here, we must differentiate between those states that have heavy welfare burdens and those that do not. Until the crisis stage of the global state-induced credit cycle is upon us, countries with low welfare costs will simply outperform the welfare states.

 

And finally, we know that the state-induced credit cycle is predictable, though its course in time and magnitude may vary. Credit expansion is followed by a credit crisis, every time. Credit expansion is the root cause behind every subsequent recession. Understand that, and you understand the futility of the system. However, we are unlikely to see mainstream economists desist from forecasting meaningless GDP numbers. But at least as individuals, we should know we would do far better to understand the business cycle is in fact a credit cycle, and accept that macroeconomic predictions are meaningless.

 

[i] See How Accurate are Private Sector Forecasts? Cross-Country Evidence from Consensus Forecasts of Output Growth. Prakash Lougani, IMF Working Paper

[ii] See: http://www.bbc.co.uk/programmes/p058qrkt

[iii] See https://www.euroresidentes.com/empresa_empresas/carta-reina.pdf

[iv] See http://www.imf.org/external/pubs/ft/weo/2016/update/02/

 

Alasdair Macleod

 

Head of Research• GoldMoney

 

 

 

 

To contact us please email rick@aheadoftheherd.com

Ahead of the Herd
www.aheadoftheherd.com