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My big reveal as macro-economics analyst: It's a load of COBBLERS

We've got simply no idea what we're on about

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Worstall @ the Weekend Welcome to the first Worstall at the Weekend, where I get to spout off on whatever I jolly well please: where the aim is to leave something at least potentially gravid with further thought and discussion rather than that sterile deposit one ends up with inside the barber's weekend supplies.

Which brings us to the discussion of why economics is so bloody awful as a method of describing the world around us. For it is bleedin' awful, as this from the FT's Tim Harford shows:

The record of failure remains impressive. There were 77 countries under consideration, and 49 of them were in recession in 2009. Economists – as reflected in the averages published in a report called Consensus Forecasts – had not called a single one of these recessions by April 2008.

This is extraordinary. Bear in mind that this is not the famous complaint from the Queen that nobody saw the financial crisis coming. The crisis was firmly established when these forecasts were made. The Financial Times had been writing exhaustively about the “credit crunch” since the previous summer. Northern Rock had been nationalised in the UK and Bear Stearns had collapsed in the US. It did not take a genius to see that trouble was on the way for the wider economy.

More astonishing still, when Loungani extends the deadline for forecasting a recession to September 2008, the consensus remained that not a single economy would fall into recession in 2009. Making up for lost time and satisfying the premise of an old joke, by September of 2009, the year in which the recessions actually occurred, the consensus predicted 54 out of 49 of them – that is, five more than there were. And, as an encore, there were 15 recessions in 2012. None were foreseen in the spring of 2011 and only two were predicted by September 2011.

I could have done, in fact did do, better than that as a hack journo. The reason being that I simply ignored all that macroeconomics stuff and looked at some of the bits of economics that we know are correct, microeconomics. Or rather, to be entirely honest I looked at people who were doing so and agreed with them.

This is an important distinction that we need to grasp in economics, this division into macro and micro: obviously, meaning large and small. But in more detail, macro is trying to explain the movements of the economy as a whole, what's about to happen to interest rates, foreign exchange, growth or unemployment.

And as I've pointed out previously and recently we don't actually have enough computing power to be able to plan our economy. We don't even know what utility function we would be trying to solve if we did have that power.

Trying to predict an economy is obviously a less intensive task: it doesn't really matter whether we have the right equations that we're trying to solve, that they work is good enough for us (and there really are people doing this sort of thing. Some good portion of HFT in the financial markets is people just trading correlations because they seem to work. They've got no idea why they work and the profits often disappear after a few weeks as the correlations do but people really are doing this).

So, say we raise interest rates, we expect GDP growth to slow. We know there're (at least) two effects going to happen: debtors have to pay more in interest so they'll cut back on other things. But obviously savers will get those higher interest payments and so will have more to spend. We think that savers will save some portion of those extra payments thus there will be a drop in overall demand.

But the point it that we don't actually know that this is true. We think it is, we've observed it a few times (and it's stunning how little empirical evidence we really have in this field. In any detail, for perhaps 30 countries over 5 or so business cycles over 5 or 6 decades - and that's about it, a very slim evidence base to construct an entire science upon) and it accords with what we think theory is.

But we're still open to being confounded on this. To change the example a little we would expect people to save less money in a higher inflation environment: might as well spend and get something rather than see your savings losing their value. Yet savings rates tend to go up in even medium (ie, 5 % and above) inflation rate circumstances as people, well, no one's quite sure what they think they're doing. We can construct a story to say that they're trying to maintain the absolute value of their savings but who knows?

Our models that we are computing this macroeconomy forecast with are based on all sorts of lightly observed linkages from our scarce evidence base and as we saw above, absolutely none of them managed to predict a recession when it was only months away. Or, if you prefer, we're just not very good at this macroeconomics stuff.

As to how I predicted the US recession at least, that was simple. I just listened to Dean Baker (a lefty but still a good economist) who entirely ignored all that macro stuff and instead pointed to a piece of micro. There's something called the “wealth effect”. When our assets, stocks, houses, whatever, go up in value we tend to spend more as we feel richer. This is why house price booms raise GDP. But crashes obviously put that into reverse and Baker pointed out that the 2006 or so real estate crash in the US destroyed some $8 trillion of household wealth: of course we're going to have a recession as households reel from such a blow.

On top of this scanty evidence-base problem for macro we also have a very sketchy command indeed of theory. I'll agree that I'm not omniscient in the subject but I'm unaware of any (I do mean any at all) statement of macroeconomic theory that you could get all macroeconomists to sign up to.

For instance let's take two that are commonly thought to be true: Firstly, the Keynesian idea that if you're in a recession you ought to try to use fiscal stimulus (government increases the gap between what it collects in taxes and spends in the economy, bridging the gap by borrowing) and thus increase demand. This shocks the economy out of a low output equilibrium into a higher output one and Hurrah! we're no longer in recession.

Hmm, well, the Austrians would say that the recession was caused by previous malinvestment and we've got to liquidate that first (and they've a point, the pre-2006 housing boom was in part fed by the fiscal stimulus applied to avoid a recession after the dotcom bust) before we can grow again. Real Business Cycle peeps will say that prices will adjust near immediately so don't screw that up by government action (as will the New Classicals to an extent) and Scott Sumner is probably right when he says that it doesn't matter because the central bank will adjust monetary policy so as to balance whatever government does with fiscal policy.

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