“worse than economists’ expectations . . .”

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.



11 Responses to ““worse than economists’ expectations . . .””

  1. Gravatar of David Pearson David Pearson
    5. March 2009 at 08:01

    Bernanke has decided, for better or worse, to target credit spreads. He is consciously saying the opposite of you: markets are wrong, they miscalculate the risk of deflation, the Fed’s goal should be to force a more accurate perception of risk.

    Assume for the moment that you are right and Bernanke is wrong. The question is, what will convince Bernanke of this fact? What is a plausible trajectory of policy towards your preferred outcome?

    The reason I ask is that TALF is highly scalable. If credit spreads don’t respond, the Fed can throw another trillion into the program, and up their MBS purchases as well. By the same token, if spreads stay low, the Fed may think it is achieving its aims, so no further stimulus is needed. This is the policy conundrum: the more the Fed succeeds in holding down mortgage spreads (the key measure of policy success), the more they will ignore equity prices and economic news. To my knowledge, mortgage spreads are no longer predicting the kind of deflation that you are. So which market is right? How does the Fed decide? When?

    I think the catalyst will be RISING treasury yields. The more deflation, the more issuance, the higher the risk premium/crowding out. The Fed will ultimately respond to a higher-yield signal by monetizing more and more of the deficit.

  2. Gravatar of Lorenzo (from downunder) Lorenzo (from downunder)
    5. March 2009 at 09:17

    Yet another fine post. I particularly commend your efforts to recover economic history. Especially how policy issues looked to people at the time.

  3. Gravatar of Alex Golubev Alex Golubev
    5. March 2009 at 09:31

    I generally agree, but this needs a caveat of self-reinforcing bubbles, no? isnt’ that the biggest issue with economics and politics. democratic voting is the best system we got, but boy does it backfire once in a while. insert churchill quote here.

  4. Gravatar of ssumner ssumner
    5. March 2009 at 10:14

    Thanks Lorenzo.

    David, I just put two long comments after your previous comment. I’m afraid this one won’t be as good because thinking about trying to control risk spreads makes my brain hurt. My hunch is that Hamilton is right when he says it hasn’t worked, but I really don’t know enough to say for sure. What will make the Fed change its mind? Continued falls in nominal GDP or even very slow growth (say 1%.)
    Regarding rising yield spreads and monetizing the debt, we have two choices:

    1. Do my policy and quickly recover–boosting tax revenues and eliminating the need for fiscal stimulus.
    2. Continue to suffer Japanese style stag-deflation, and see our national debt continue to swell.

    Yes, my plan would boost T-bond yields back up to 5% or so, but which plan is more likely to lead us into to an unsustainable fiscal situation in the long run?

    Alex, I will try to do three posts you want in March

    1. 1932 OMOs and summer stock rally
    2. Why Churchill was wrong about democracy (even though common sense says he was right.)
    3. Why the irrational exuberance theory of bubbles is useless (again contrary to common sense.)

  5. Gravatar of Carl Futia Carl Futia
    5. March 2009 at 10:20


    Could you post the precise reference for the quote from Einzig that you used in this post? (The title is missing…)


  6. Gravatar of travis travis
    5. March 2009 at 12:57

    How did the inflation in 1936-7 from the collapse of currencies tied to the price of gold result in a depression? Did the Fed start to tighten because of the inflation?

  7. Gravatar of Alex Golubev Alex Golubev
    5. March 2009 at 15:41

    I’m looking forward to your posts, particularly given those previews!!! 🙂 Thanks

  8. Gravatar of Alex Golubev Alex Golubev
    5. March 2009 at 15:52

    1932 OMO paper – gotta do my research:

  9. Gravatar of ssumner ssumner
    6. March 2009 at 16:57

    David, A few more responses and then questions. I think it is very dangerous for the Fed to bet against the markets. Bernanke has been behind the curve almost throughout the crisis. And this is despite my earlier post arguing that in principle the Fed has “inside information.”

    You and Carsten in the “Let Bernanke be . . .” comment section would be shocked at how little I know about credit markets. But I rationalize it this way: If drug dealers suddenly demanded huge amounts of $100 bills, that would be deflationary unless the Fed increased the base. (But I know nothing about drug dealers) If our financial system is falling apart that will reduce NGDP sharply, unless the Fed accommodates the extra demand for MB. And here my argument is stronger than the drug example, because falling NGDP is also actually worsening the financial crisis. By the way, I wonder if you and Carsten can educate me a bit on this subject:

    1. Does the TALF and MBS necessarily boost the MB? Do they in practice?

    2. Why did the base fall 200b a few weeks ago? Is the Fed not really doing QE, but just sort of accommodating a collapsing financial system, as in 1931-32? I really don’t know, but there would seem to be no logical reason for reducing the base. If credit programs were winding down, why not just buy some more T-bills and keep the base from falling? They are not afraid of inflation are they? And if they are, why does Bernanke favor fiscal stimulus?

    As I mentioned in the next comment section, I have been sloppy talking about “deflation” when I really mean falling nominal GDP. We had some deflation in recent months, but the official indices will probably show level prices for a while going forward. The real problem is NGDP. Going from 5% growth to almost 7% negative is devastating. In my Depression manuscript I argue that under AD shocks, NGDP many actually measure changes in the ‘true’ price level more accurately than the official CPI or GDP deflator. Thus if rents fall 2% and house prices fall 20%, the CPI will use rents. But that’s another subject.

    Carl, The title is “Will Gold Depreciate?” from 1937.

    Travis, You are partly right, but the bigger story will be discussed in my Depression post Saturday, or probably Sunday (I have another planned first.)

    Alex, I partly disagree with Romer and Hsieh, (and F&S), although their argument is not indefensible. I will cover that in a few weeks. If you need the info right away for some project, I can email you my chapter on 1932, or you can look at an article I published on this episode

  10. Gravatar of Where Jobs Are Where Jobs Are
    7. March 2009 at 23:11

    I should have discovered this great discussion long time ago. Many thanks!

  11. Gravatar of 三つの10月 by Scott Sumner – 道草 三つの10月 by Scott Sumner – 道草
    17. February 2011 at 01:48

    […] 私はこのモデルを検討する中で、 1936-37年に物価を押し上げた要因は三つあることに気づいた。1936年遅く、フランスなどの国々が金本位制を離脱したので中央銀行が金を放出した。またロシアの金輸出が増加し、ロシアからはもっと大量の金が出てくるのではないかという(間違った)予想も広まっていた。さらに、ヨーロッパで金本位制が崩壊すると大量の金が米国に流入してインフレになるのでFDRもドル切り上げを強いられるのではないかという恐怖が発生し、民間が金を放出した。「経済学者の予想よりも悪い…」のエントリで引用したポール・アインチヒの言葉はこのことだ。 […]

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