Crises can’t be forecast

Here’s a graph from a recent David Beckworth post:

Spot commodity prices can’t be forecast (EMH.)  Spot commodity prices are highly correlated with the business cycle.  Ergo, the business cycle cannot be forecast.  This is in response to a recent Tyler Cowen post:

Raghu Rajan nails it:

“I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.”

Rajan’s second point is exactly right.  The other two are completely irrelevant.  Someone please tell the Queen.


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39 Responses to “Crises can’t be forecast”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2011 at 10:56

    I’m a comparative novice (despite being in my 40s) but let me offer my completely biased opinion:

    1) Specialization

    Not a problem. For example, I’m a macroeconomist and yet many would consider me much more competent in micro. My general perception is that most PhD economists know a great deal about most branches of economics.

    2) The difficulty of forecasting

    One might as well be looking at animal livers and tea leaves.
    Anyone who can accurately forecast the future probably should get a TV show like “The Amazing Kreskin” did in the 1970s:

    http://www.amazingkreskin.com/

    3) The disengagement of much of the profession from the real world.

    This is where I disagree with you Scott. The RBC/Neo-Classicists totally live in a cocoon. Robert Lucas had to be given a swift kick in the ribs before he even noticed there was a recession.

  2. Gravatar of david david
    6. February 2011 at 11:06

    This doesn’t say that crises can’t be forecast. It only says that reliably correct forecasts will be rapidly integrated into price information. 😛

    There’s only so much one can do to hedge away, say, an oncoming earthquake. The occurrence of earthquakes may still be a random walk; it’s just a random walk you can sometimes see coming. Cue a real shock.

  3. Gravatar of david david
    6. February 2011 at 11:07

    (but besides that nitpicky element, I must agree that yours is a wonderfully piercing insight. Hmmm.)

  4. Gravatar of marcus nunes marcus nunes
    6. February 2011 at 11:26

    Scott
    I tried to expand on DB´s evidence in support of Bernanke´s non responsability for food price increases:
    http://thefaintofheart.wordpress.com/2011/02/06/bernanke-and-higher-food-commodity-prices/

  5. Gravatar of Indy Indy
    6. February 2011 at 11:39

    One could say that because we also can’t currently accurately predict future NGDP levels, we also can’t predict when changes in that trend will lead us into crisis.

    Solution: Guarantee Future NGDP levels.

  6. Gravatar of Morgan Warstler Morgan Warstler
    6. February 2011 at 11:47

    “and the disengagement of much of the profession from the real world.”

    Scott, you have NO cell phone. Until you get one, I’m discounting all your ideas by 45%.

    I’m going to mention it over and over and over.

    You can earn 20% back if you read this article from 1997:

    http://www.wired.com/wired/archive/5.09/newrules_pr.html

    While reading, try and imagine how if it is right in all its assumptions, fiat them correct, stipulate to them – what does it do, if anything, to your analysis of growth.

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2011 at 11:59

    Morgan,
    Just to irritate you I should mention that I have no cellphone either (but I do have all the other modern conveniences). I get by much better without one (and I save some money to boot). I found it to be a major distraction and so I discontinued it.

    I sometimes stare in amazement at my (older) brother furiously texting his latest (younger) girlfriend and totally ignoring me when he visits and ask him “Why are you here? Why don’t you just go over her apartment and talk to her in person if that’s your preference?”

  8. Gravatar of marcus nunes marcus nunes
    6. February 2011 at 12:24

    Mark
    It´s not an either/or thing about cellphones. I think they expand your options. I don´t use it to text away, just to make calls and choose the ones I answer immediately. Once my car broke down late at night in a deserted stretch of road. Calling the tow-truck was a piece of cake. Another time I could have been mugged!

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2011 at 12:34

    Marcus Nunes,
    Your good point is well taken. However, I broke down on an incredibly rural road two weeks ago and someone stopped within minutes (it’s a very friendly country, the US) and let me call for a tow. In the meantime someone else had already called the police to help manage any “traffic” problems. I guess that makes me a free rider.

  10. Gravatar of marcus nunes marcus nunes
    6. February 2011 at 12:57

    Mark
    OK. The “option value” is higher in a more hostile environment like the one I live in!!!

  11. Gravatar of jean jean
    6. February 2011 at 13:20

    Here are two replies to the Queen you would agree, one of which she might have heard of:
    http://aidwatchers.com/2009/08/the-idiot%E2%80%99s-guide-to-answering-queen-elizabeth/
    http://www.voxeu.org/index.php?q=node/3996

  12. Gravatar of JL JL
    6. February 2011 at 13:54

    Bravo good sir, bravo.

    That is one heck of a watertight proof.

  13. Gravatar of gregransom gregransom
    6. February 2011 at 14:10

    one mans modus ponens is another mans modus tollens. 😉

  14. Gravatar of greg ransom greg ransom
    6. February 2011 at 14:13

    one mans modus ponens is another mans modus tollens

  15. Gravatar of greg ransom greg ransom
    6. February 2011 at 14:15

    Isn’t this the very picture of Hayekian macro?

  16. Gravatar of mbk mbk
    6. February 2011 at 16:16

    Another take would be: If crises could be forecast they wouldn’t be let to happen. Or more precisely, if endogenous crises (coordination failures etc, not exogenous ones like earthquakes) could be forecast reliably, they wouldn’t even develop because they would be prevented from doing so.

  17. Gravatar of Rien Huizer Rien Huizer
    6. February 2011 at 18:30

    Questions:

    1. has this correlation existed for a very long time (like since the beginning of national accounting)?
    2. even if the vast majority of economists had guessed right accidentally, would there have been a political response (i mean coordinated use of tools available to the public sector incl the fed)?
    3. if that political response had been effective (ie reducing the amplitude of the cycle) would not all those economists be considered wrong ex post?
    4. if economists could forecast business cycles, would the correlation hold?
    5. if the correlation would hold would not the majority of economists become unbeatable hedge fund managers no longer interested in doing academic work (but conduct the economic speculation they used to do pro bono)
    6. would anyone listen to those pro bono opinions of formerly distinguished academics since everyone would assume they would be talking to towards a position?
    7. Maybe we should leave economics to applied mathematicians who are more interested in models than reality (I used to work with lots of “quants” who tended to have great difficulty in a trading environment: too much distraction and noise…Not quite the same as academics opining on real world economics, but still) and let politicians make their own mistakes without PhD fall guys by their side (politicians may not have high IQs, but they have to be very smart to survive)?

    Would you be interested in the next 7 questions?

    But all in all, I think it is unreasonable (as you suggest too) to expect economists to forecast events that can be attributed to so many moving parts.

    What they can do is issue “warnings”, like weather bureaus do. For instance, a representative panel of economists, representing most major sects, could state that the business cycle during the next year (?) may be disappointing, especially in areas like X aY and Z and that the chances ate that this event will be more severe than the past 3 ones.

    However they would, responsibly, that if people would heed this warning, supply side confidence would drop and the dip would occur earlier in the warning period. In order to prevent this , people should ignorte the warning, while the gvt and the monetary controller would be ready to intervene as soon as signs of this event would materialize..

  18. Gravatar of Bryan Willman Bryan Willman
    6. February 2011 at 21:38

    Given that many very credible authorities correctly predict that smoking in bed will cause fires and severe burn injuries, and people still do it,

    And that everybody already knows, and all experts agree, that eating too much and exercising too little causes excess body weight, and this is bad for you, but enourmous numbers of people are unable to avoid this outcome,

    Why does anybody think any sort of economic forecast that ever required calling an end to a bubble, or being realistic about what govt. could offer people, would ever be acted on?

    In short, the answer to Huizer’s #2 will always be NO, until the prediction has come true, and reality is very pressing, and there is no choice.

  19. Gravatar of Bryan Willman Bryan Willman
    6. February 2011 at 21:43

    By the way –

    The very question assumes that predicting the crash and avoiding it would actually be better than having the crash.
    One likes to think this, to hope for it, but it’s not necessarily so. Crashes are bad, but it might be that often the alternatives to a particular crash would all be worse.

    What’s more, I sometimes wonder if crashes and other crises and failures are actually necessary. That the turmoil, forced changing of rules, forced shakeups, and so on, are actually required to sustain anything that looks like progress. (But this would never be sufficient, only necessary.)

  20. Gravatar of david david
    7. February 2011 at 02:57

    Greg, when did Hayekian macro start including EMH?

  21. Gravatar of Rob Bennett Rob Bennett
    7. February 2011 at 06:11

    Here’s a link to recent research showing that Valuation-Informed Indexing (changing your stock allocation in response to big price swings) beats Buy-and-Hold (staying with the same stock allocation at all times) in 102 of 110 rolling 30-year periods:

    http://wpfau.blogspot.com/2011/01/valuation-informed-indexing-preliminary.html

    If long-term stock returns can be predicted, does it not follow that the economic crises that always follow from huge bull markets can be predicted as well?

    The U.S. market was overvalued by $12 trillion in 2000. Prices always return to fair value in 10 years or so. Is it really so hard to predict that an economy that is going to lose $12 trillion of spending power is going to collapse? Isn’t it just basic math?

    Rob

  22. Gravatar of Mattias Mattias
    7. February 2011 at 06:30

    On the third point: I think it was Edgar Fiedler who said “For economists the real world is often a special case”.

  23. Gravatar of Greg Ransom Greg Ransom
    7. February 2011 at 08:59

    David, Hayek doesn’t include the EMH. (Hayek argues against a 1920’s macro economist version in his _Monetary Theory and the Trade Cycle_. Note well. Historically as the EMH developed in the theoretical literature of statistics and finance is something different from what you find assumed by the macro modelers).

    I was referring to the graph, not to anything in Sumner’s text.

  24. Gravatar of Philo Philo
    7. February 2011 at 09:02

    Tyler can be remarkably uncritical. He is *impressed* when Rajan (a) “explains” economists’ failure to forecast the Great Recession by pointing out that economic forecasting is *very difficult*–and also (b) adds two further (implausible) explanations, without remarking that these latter two are not on the same plane of comprehensive triviality as the former one. Not an impressive performance by either party.

  25. Gravatar of Greg Ransom Greg Ransom
    7. February 2011 at 13:47

    If we take Lucas’s word for it, Lucas’s version of rational expectations economics was inspired in large measure by Hayek’s casting of the problem of macro-econ and Hayek’s micro-foundational work.

    David wrote,

    “Greg, when did Hayekian macro start including EMH?”

  26. Gravatar of Scott Sumner Scott Sumner
    7. February 2011 at 14:49

    Mark, You are probably right.

    David, If you are right, we won’t be able to forecast it until it’s already occurred.

    Marcus, I agree that China is the key factor, but to a lesser extent the entire developing world is becoming more important.

    JL, Glad you agree.

    Morgan, Wrong post.

    Indy, If you mean level targeting, I agree.

    jean, Those are good arguments.

    Greg Ransom, You are forcing me to look up Latin phrases.

    mbk, You said;

    “Another take would be: If crises could be forecast they wouldn’t be let to happen.”

    I was working on a paper making that claim in 2008, right before the crisis struck.

    Rien, All good points. Many of those ideas have also been swirling around in my head.

    Bryan, I think it would be better to avoid severe recessions, but not necessarily better to prevent asset price declines.

    Rob, You said;

    “If long-term stock returns can be predicted, does it not follow that the economic crises that always follow from huge bull markets can be predicted as well?”

    There are millions of market anomalies. The EMH predicts there will be millions of market anomalies. Looking for market anomalies is not the right way to test the EMH. The right way to test is is to see whether mutual fund excess returns are serially correlated. And they aren’t.

    Mattias, That’s a good line.

    Philo, I agree.

  27. Gravatar of Robert Simmons Robert Simmons
    7. February 2011 at 16:21

    Why didn’t economists foresee the crisis? Because of “the difficulty of forecasting”.

    I wish I had been able to make this sort of argument when I got mediocre grades in school. Why did I occasionally get a C? Because of the difficulty of doing well in school. Oh, well then, that explains it, no problem.

    I mean, I agree that it’s true, but it’s not an explanation.

  28. Gravatar of marcus nunes marcus nunes
    7. February 2011 at 16:24

    “China” is just a stylized fact. Much like the US pulled Europe after the war, China is “pulling” a group of emerging mkt countries. Unfortunately, China is not the US!

  29. Gravatar of Greg Ransom Greg Ransom
    8. February 2011 at 08:15

    Scott. Here’s the English:

    Scientists #1 and #1 are talking about the same deductive argument …

    Scientists #1:

    “The patent falsity of your conclusion establishes by deduction the falsity of one of your premises.”

    Scientists #2:

    “The patent truth of my assumptions proves the truth of my conclusion.”

  30. Gravatar of Greg Ransom Greg Ransom
    8. February 2011 at 08:15

    #1 and #2

  31. Gravatar of Greg Ransom Greg Ransom
    8. February 2011 at 08:17

    Forecasting is especially hard when your “science” is crap — i.e. when its fake science all the way down.

    Robert writes,

    “Why didn’t economists foresee the crisis? Because of “the difficulty of forecasting”.”

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  33. Gravatar of Scott Sumner Scott Sumner
    10. February 2011 at 05:56

    Robert, I agree. The actual reason is the EMH.

    Marcus, I’d distinguish between China raising commodity prices (true) and China rescuing developing countries (not true in the long run.)

    Greg, Statistics is also bunk, as statisticians cannot forecast where the ball will end up on the roulette wheel.

  34. Gravatar of Mark A. Sadowski Mark A. Sadowski
    10. February 2011 at 10:01

    Mostly off topic.

    Here’s an interesting post by James Kwak on Representative Paul Ryan’s grilling of Bernanke concerning the ever impending hyperinflation yesterday. Apparently he pointed out an AEI study on the recent alarming run up in price of a particular basic commodity:

    http://baselinescenario.com/2011/02/09/paul-ryan-criticizes-bernanke-for-failing-to-contain-tooth-fairy/

    Menzie Chinn did a nice follow up.

  35. Gravatar of ssumner ssumner
    11. February 2011 at 19:35

    Mark, Maybe I’m dense, but I think I missed the joke. Or maybe I got it, and didn’t find it all that funny. I’m not sure which.

  36. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. February 2011 at 19:41

    Scott,
    You’re not alone. People plenty brighter than you evidently failed to get the joke. Read it and all the responses a few more times. (I’m not all that bright but I like a really good joke.)

  37. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. February 2011 at 20:04

    Menzie had a story on this as well (the link is not transferable for some reason). Read it. You will find some familiar names. It is dry humor.

  38. Gravatar of Scott Sumner Scott Sumner
    12. February 2011 at 13:56

    Mark, The problem is that no one quotes Ryan talking about teeth. Without the quotation, the humor doesn’t work (with me.)

    Or maybe I missed the quotation.

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