It seems like I have seen the title phrase of this post in almost every economic report for the last 6 months. This time it was in a Yahoo article about job losses in February. Early last October when stocks and commodities crashed, and inflation expectations in the indexed bond market started falling sharply, it was pretty obvious that the markets expected a sharp drop in nominal GDP. It’s been my impression that the private consensus forecast, and especially the Fed, has trailed far behind the markets in understanding the severity of the crisis. The private consensus forecast has seemed to fall almost every month for over a year, whereas under Ratex it should be a random walk (or have I misunderstood something here?)
Recall that Bernanke used to argue that if there was a threat of deflation, the Fed had to move very aggressively to avert a liquidity trap. They certainly did not do that. On October 6th, when the Fed adopted the highly deflationary policy of paying interest on reserves, the fed funds target was still at 2%, and had not been cut one basis point since late April. Why wasn’t it already at zero? Even at zero the market’s nominal GDP growth forecast would almost surely have been below the Fed’s target.
I suppose some people will say “what do you mean the Fed has been passive? They’ve poured over a trillion dollars of liquidity into the banks, doubling the monetary base.” Yes, and paid interest on those reserves. The only policy that can be said to be truly expansionary, is a policy that boosts market expectations of nominal growth. And the Fed hasn’t done that.
When I realized what was going on I drove to Cambridge, Massachusetts, like a latter day Paul Revere trying to warn the faculty that “the deflation is coming, the deflation is coming!” Well, actually that falling nominal GDP was coming.
(BTW, I hate having to always say nominal GDP–why couldn’t the default position for “GDP” be “nominal” and if you want to indicate “real GDP,” say so, as you would for any other variable. Sometimes even the choice of language can be subtly revealing about flaws in our thinking. And while I’m at it, why not just call nominal GDP “aggregate demand,” and make the AD curve a hyperbola. Wouldn’t it simplify macro to divide up shocks into nominal and real shocks?)
You might assume that I am claiming to be some sort of Nostradamus. Nothing could be further from the truth:
I don’t make forecasts, I infer market forecasts.
That is, I look at all the various financial and commodity markets, and try to estimate what they think will happen to the economy. It is far from perfect, but 100 times better than I could come up with on my own. I never would have expected sharply falling NGDP if the markets hadn’t told me it was coming.
This is not false modesty, (as you would find out if you checked my 403b balance.) Why didn’t I sell my stocks? Because I thought it was too late, that deflation was already priced into the stock market after the crash. In addition, I suppose I assumed the Fed would see what was going on and change course. Big mistake. As pessimistic as the market was in October, it was no where near pessimistic enough.
The first time I ever heard this “populist” take on economic forecasting was in the early 1970s, when (if I am not mistaken) Arthur Laffer forecast nominal GDP growth based on financial markets, and beat the forecasts of the major econometric modelers. (I am rely on memory, here, perhaps someone can tell me if they recall this incident. The very underrated Paul Einzig has a wonderful example from way back in early 1937, when gold dishoarding following the collapse of the gold standard in Europe, along with rumors of huge Russian sales of gold, drove commodity prices sharply higher in gold terms during late 1936 and early 1937. It was called a “gold panic,” and although it contributed greatly to the severe 1937-38 depression, it is (like George Warren’s gold-buying program), virtually ignored by modern economic historians. The panic led to high inflation in countries (like the U.S.) with currencies pegged to gold:
“On June 9, 1937, this veteran monetary expert [Cassel] published a blood-curdling article in the Daily Mail painting in the darkest colours the situation caused by the superabundance of gold and suggesting a cut in the price of gold to half-way between its present price and its old price as the only possible remedy. He took President Roosevelt sharply to task for having failed to foresee in January 1934 that the devaluation of the dollar by 41 per cent would lead to such a superabundance of gold. If, however, we look at Professor Cassel’s earlier writings, we find that he himself failed to foresee such developments, even at much later dates. We read in the July 1936 issue of the Quarterly Review of the Skandinaviska Kreditaktiebolaget the following remarks by Professor Cassel: ‘There seems to be a general idea that the recent rise in the output of gold has been on such a scale that we are now on the way towards a period of immense abundance of gold. This view can scarcely be correct.’ . . . Thus the learned Professor expected a mere politician to foresee something in January 1934 which he himself was incapable of foreseeing two and a half years later. In fact, it is doubtful whether he would have been capable of foreseeing it at all but for the advent of the gold scare, which, rightly or wrongly, made him see things he had not seen before. It was not the discovery of any new facts, nor even the weight of new scientific argument that converted him and his fellow-economists. It was the subconscious influence of the panic among gold hoarders, speculators, and other sub-men that suddenly opened the eyes of these supermen. This fact must have contributed in no slight degree towards lowering the prestige of economists and of economic science in the eyes of the lay public.” (1937, pp. 26-27.)
Remind anyone of recent history? I wish every macroeconomist would study Einzig’s word’s and think about what he is saying here. Surowiecki showed in The Wisdom of Crowds that the forecast of a crowd of average people will beat the forecast of a single expert almost every time. (In a later post I hope to talk about Robin Hanson’s interesting work on this topic.) Given a choice between the forecast of a single superman, and a market full of “sub-men”, I’ll go with the sub-men. I already had developed this perspective before the current crisis, but the past 18 months has erased any doubts I might have harbored about the optimality of market forecasts of NGDP growth. They’re far from perfect, but better than any alternative.
By the way, Bill Woolsey has sent me some useful data on NGDP growth since 1995. (Both June 1995 and June 2008 had 5.6% unemployment rates.) He confirms my guess that NGDP growth has averaged slightly over 5% in recent years, and his data shows how we are now falling sharply below trend.