It’s always an honor to be noticed by The Economist. Unlike Eugene Fama, I don’t plan to cancel my subscription to the best magazine in the world, even if they say this about me:
Mr Sumner disagrees. He seems to think it’s funny that The Economists pent much of the last decade warning that, globally, home prices were rising in a troubling manner. Contrarianism is fun and all, but this strikes me as an odd way to process the experiences that led us to this point.
A few comments:
1. I would note that Free Exchange seemed to enjoy making fun of Fama’s views.
2. I do think it funny that Free Exchange would claim that The Economist was exactly right in its housing bubble predictions. Then demonstrate this by linking to an excerpt from The Economist that was 180 degrees off. That predicted American housing prices would fall 10% over the 4 year period after May 2003, when they actually rose about 30%.
3. I do admit to forgetting that The Economist is real people, as they don’t tend to list names of reporters. So perhaps that made me more sarcastic than I should be.
4. I use humor to wake people up, to try to make points more accessible.
5. The crisis of the past year has consumed all my time. I’d much rather be reading books or seeing movies, and my school doesn’t compensate me for this. I am deadly serious about trying to wake people up to the incredible harm done by tight money in 2008. Unfortunately I seem to recall The Economist advocating tighter money, on the grounds it was needed to squeeze the excesses out of the US economy. It looks like they got their way, and it looks like that monetary policy made the housing crash prediction look even more impressive than otherwise.
I don’t want to be dogmatic about this. I’ve never denied that the EMH is merely an approximation of reality. Or that astute observers do sometimes have insights that the markets miss. But that doesn’t make Fama wrong. Social science is not about the exceptions, it is about broad principles. I presume that “the market” does gain some value from the information in The Economist. But here is the problem; that fact doesn’t really give the anti-EMH position any real traction. Useful insights in The Economist are just as available to “the market” as they are to “the regulators” or to me. If I invest based on advice from The Economist, I won’t consistently beat index funds. And if regulators try to predict bubbles based on predictions from The Economist, they’ll do no better than they would by throwing darts at a stock page.
Here is one accurate prediction I did make. In my previous post I showed that the 2003 Economist prediction that everyone seems to think was amazingly accurate was actually almost completely wrong. I said I expected comments that somehow it was actually correct. They are already coming in. People are saying something like “yes, they explicitly predicted a 10% fall over 4 years. And yes, prices actually rose 30%, but they rose 35% in three years and then fell 5% in the 4th. So they were right.” Well not in those exact words, but that seems to be the general view out there. Another argument is that they were wrong in the 4 year window, but then spectacularly right in the 5th.
Yes, but if we don’t have standards, if we aren’t going to hold people to their words, then what do we really have? Suppose I said; “I predict a major 20% to 30% drop in the S&P500 within the next 4 years. And if it doesn’t happen, but happens sometime later, I should still get credit.” Would you take me seriously? People don’t seem to understand that unless a prediction is both accurate and timely, it really isn’t of much value.
The Economist seems to have wanted the Fed to do something in 2003. But what if the Fed had tightened, perhaps we would have gone into a Japanese style deflation/zero rate trap. Then what? I will concede that The Economist was probably right about monetary policy in 2004 and 2005, in retrospect a bit more restraint would have helped. But May 2003? That is still very much an open question.
We all interact with our fellow humans. I am sure that you observe the same things I do, our acquaintances are absurdly overconfident in their predictions in sports, politics, economics, everything. It’s human nature. But we all go along to be polite. I am the same. Obviously it’s a bit absurd for me to think that a professor at Bentley has the answer to the world’s financial crisis. But I think I do. I act as if I do. I am as arrogant as you expect such a person to be.
You might ask why then do I want the Fed to adopt my policies? The answer is that I don’t expect them to do so merely on my say so. I think Bernanke would be foolish to adopt my ideas unless other more distinguished economists have also come on board. The goal of my blog is to start a conversation among economists about the possibilities for unconventional monetary stimulus. Being a libertarian with slight monetarist tendencies, I have been surprised that in recent months the conversation in this direction has been more noticeable in liberal/Keynesian blogs such as Krugman/DeLong/Yglesias. But any news is good news.
Free Exchange says we can have confidence that The Economist’s prediction was not luck, because they gave lots of good reasons for that belief. I agree that helps. But consider this analogy. Suppose you have a friend who predicts his football team will lose in the first round of the playoffs. He cites two reasons, the quarterback is inexperienced in big pressure games, and the star running back is injured. Now suppose they win all their playoff games and go to the Super Bowl. The prediction was wrong. But suppose they lose in the Super Bowl because they have no running game and their quarterback looks very shaky under pressure. I’ll bet the average fan would say “Aha! I knew that was going to happen.” We remember our successes and forget our failures. Even worse, we shape the game’s narrative to fit our predictions. The Economist could have written articles saying:
1. A 2007 crackdown on immigration sharply slows US population growth in the Southwest. Housing starts to slump. High energy prices hurt commuters with long commutes. Home prices slump in the exurbs.
2. Tight money by the Fed in 2008 causes NGDP growth to slump 8% below trend. Unemployment soars. Nominal incomes fall at the fastest rate since 1938. This further weakens an already shaky housing market.
But that’s not what most journalists wrote. They wrote a narrative that fit their preconceived ideas about what happened. Am I claiming that those other factors didn’t play a role? Of course not. But wouldn’t it be equally absurd to write a narrative that didn’t give prominent mention to the factors I just cited? Especially since the fall in NGDP closely correlates to the housing crash spreading nationwide? I think you’ll agree that it would be negligent. But that doesn’t stop most financial reporters from ignoring those other factors.
[BTW, before you say “immigration doesn’t explain the other countries” consider that those crashes tended to occur later than the US. And were correlated with falls in NGDP. And the one country where NGDP didn’t fall? Oh that’s Australia, the one country where The Economist’s prediction wasn’t even right in the long run. They had no housing crash at all according to my commenter from down under. I wonder how The Economist would explain that.]
One final comment. When I ask people why a mutual fund run on their insights about fundamentals would not beat an index fund, they often dodge the question by talking about the difficulty of selling stocks short. But again, if you really can know the fundamentals, there are plenty of profitable long positions in various markets around the world, and in the brief period when there might not be, just park the money in index funds. I still say that type of mutual fund wouldn’t reliably beat an index fund. And I still say the implication of the bubble theorists is that it would. I can’t quite tell what the view is at Free Exchange:
I feel like this is the sort of critique that sounds lovely so long as one remains comfortably in the realm of abstract intellectualism. The price-to-income ratio has risen above its long-term trend, but how can we know that it’s a bubble? Fundamentals? Well, perhaps they’ve shifted. And if you’re so confident, why aren’t you ringing up your trader and telling him to short housing?
Yes, that is my question. And the answer is that if you had shorted housing builders in May 2003 you would have gone bankrupt. But then he seems to want to have it both ways:
Some people managed to make money off their models of the bubble despite the significant logistical difficulty in betting against housing markets.
Those would be people who ignored The Economist in 2003 and went short in 2007. I do accept one part of this argument. Housing is harder to short than stocks, bonds, commodities and currencies. But that really doesn’t help Free Exchange’s argument. You see The Economist is equally opinionated about these other assets. Which does imply that an “Economist mutual fund” should reliably outperform index funds. I say it wouldn’t. Robin Hanson suggests we need to test this. I don’t think so. It’s like astrology. As soon as you start suggesting to an astrologer that we do tests of whether personality types correlate with birth month, their whole attitude changes. “It’s more complicated than that.” There will never be the sort of test Hanson wants because no one has enough confidence in the musing of The Economist on fundamental values of stocks, bond, commodities and currencies to even lift a finger setting up such a mutual fund.
If this has been too negative, how about ending on this note. What would make the world a better place is not people investing or regulating on the basis of The Economist’s asset price predictions, but rather governments around the world switching to the sort of high saving neoliberal economic model that The Economist advocates. That’s what makes them the best and most valuable magazine in the world—their influence on policymakers.