Winners & Losers 2010: The false prophets – Economists

With the economy refusing to obey models and forecasts, the question increasingly arises: do economists know anything?

See also, ‘ False prophets‘ gallery for a review of the top economists’ and business figures’ forecasts.

&#9660 Sherry Cooper is the top gun in her field, according to the W.P. Carey School of Business at Arizona State University. Last month, the chief economist of the BMO Financial Group received the Lawrence R. Klein Award — which recognizes accuracy in economic forecasting — for doing an outstanding job of reading market indicators. “She was the most accurate in an impressive field of the world’s best forecasters,” says Lee McPheters, director of the school’s JPMorgan Chase Economic Outlook Center.

But Cooper hasn’t always made headlines for hitting the nail on the head. In 2001, she urged Canada to adopt the U.S. dollar before our buck became worth less than two American bits. “Now that the loonie has rebounded to a whopping 63.5 cents, the talk of dollarization has dissipated,” she wrote in a National Post column, but added that she retained a conviction in the loonie’s “inexorable, long-term downtrend.” As irony would have it, Canada’s currency was giving Uncle Sam’s greenback a run for its money at the time Paul Volcker, chairman of the Obama administration’s Economic Recovery Advisory Board, was handing Cooper her prize.

In the dismal science, accurate projections are indeed something to celebrate, and that’s especially true these days. Remember the V-shaped recovery bullish economists insisted would follow the Great Recession? Or the double-dip downturn the Negative Nellies just as confidently predicted? So far, neither has come to pass.

It’s tempting to suggest that economists’ real role is to make astrologers look good, but the problem is no joke. After all, the financial world has been lurching from one crisis to another ever since the U.S. housing bubble popped in 2006 and exposed the sub-prime mortgage fiasco. Amid a floundering economy that no one seems to know how to fix, experts and lay people alike are questioning whether economics is really a science or merely an illusion of one.

Terry Connelly, dean of the Ageno School of Business at Golden Gate University in San Francisco, defends economics as a discipline still finding its way. He points out that a good free-throw shooter in the NBA has about a 90% success rate, while a baseball star is lucky to bat above .300. Economists, he says, strike out often because that’s the nature of the complex game they play. “We sometimes hold [their] predictive capacity to too high a standard,” Connelly adds.

A growing number of critics, however, insist the problem isn’t our exaggerated expectations but economists’ claim to a knowledge they simply don’t have. One of the most vociferous detractors is David Orrell, a Canadian mathematician and author who argues that the real-world economy is nothing like what is taught in school. Actual economies, Orrell says, are unfair, unstable and unsustainable, but economic theory has no way of addressing these issues because it sees markets as inherently stable and efficient allocators of resources with limitless growth potential.

Tracing economic laws from Pythagoras to Wall Street, he concludes that they are based on anachronistic theory. “Economics,” he writes in Economyths: Ten Ways Economics Gets it Wrong, “is a mathematical representation of human behaviour.” Like any mathematical model, he notes, it uses certain assumptions, but economic assumptions “are so completely out of touch with reality that the result is a highly misleading caricature. The theory is less of a science than an ideology.” According to Orrell, the world needs to throw out economic textbooks before Adam Smith’s invisible hand — which he insists has “a bad case of the shakes” — destroys everything from our life savings to Mother Earth.

Orrell is an outsider with an environmentalist agenda, but plenty of industry insiders also see need for reforms. “Frankly, I think economists are even more guilty [of failure] than charged,” says David Levy, chairman of the independent Jerome Levy Forecasting Center, which publishes the oldest economic analysis newsletter in the U.S. He points out that we’ve just gone through a period of dramatic upheavals in the health of the markets and private-sector balance sheets. “Debt levels have risen faster than incomes. We’ve had breakdowns in the financial sector, massive writeoffs, contractions in asset prices and dramatic swings in profitability, liquidity and cash flow. And every single one of these topics doesn’t exist in the neoclassical paradigm, which is the foundation of conventional economics. This is a problem.”

Levy thinks the world needs more followers of Hyman Minsky, an economist who stressed the influence of bank balance sheets, market misinformation and systemic uncertainty.

David Malpass, a former Bear Stearns chief economist who served as a state and Treasury official during the Reagan and Bush years, has also grown skeptical. He points out that the policy tools used to stimulate national economies were “invented when we were on fixed exchange rates.” As such, there is little reason to expect them to work today, since the world’s financial system changed dramatically in the early 1970s when the U.S. set exchange rates afloat.

Even central bankers are openly questioning the assumptions used to justify current macroeconomic policies. The U.S. Federal Reserve, for example, is widely expected to initiate a second round of so-called quantitative easing. QE is essentially the tool of last resort for monetary policy-makers who have cut interest rates to zero and still want to do more to juice the system. According to the textbook “money multiplier” model, central banks can stimulate lending and economic activity by printing money and injecting it into the banking system. Yet two researchers — one of them a senior Federal Reserve staffer — recently pointed out in a paper that bank lending has failed to soar despite a dramatic increase in American bank reserves that followed the implosion of Lehman Bros. In 2008, U.S. bank reserves were at less than US$50 billion; today, they are over US$1 trillion, a jump of more than 2,000%. But American loan activity actually dropped by about US$140 billion over the past two years.

“Simple textbook treatments of the money multiplier give the quantity of bank reserves a causal role in determining the quantity of money and bank lending,” they write. “We have demonstrated that this simple textbook link is implausible.” The study further erodes confidence in central bank policies by citing a speech by former Fed vice-chairman Donald Kohn in which he suggested that QE needs further study.

“Fed officials are clueless,” concluded independent investment strategist Ed Yardeni in a related commentary. He pointed out that the money multiplier had been called into question in a previous study co-published by none other than Fed chairman Ben Bernanke — one of the many respected economists, incidentally, who predicted in 2007 that the sub-prime crisis would be contained. “Did you catch that?” Yardeni asks. “Bernanke knew back in 1988 that quantitative easing doesn’t work. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.”

According to Yardeni, the fiscal multiplier concept taught in schools “is also baloney.” He notes the Keynesian notion that $1 of additional government spending will generate $1.5 of real GDP certainly didn’t pan out in the wake of the Obama administration’s US$800-billion American Recovery and Reinvestment Act.

Even critics admit economics can be a useful, and profitable, tool. Ross Junge, a portfolio manager with Aviva Investors, which manages US$400 billion in global assets, argues that studying the dismal science can give professional market players an edge. But since much of economic theory didn’t anticipate the global financial sector, he can’t imagine why any economist would make a career as a high-profile forecaster. Doing so offers little gain while presenting a high risk of ridicule. “Being a pure economist and openly putting your neck on the line with point-in-time estimates of GDP is a bit like studying meteorology and becoming a weatherman.”

In the end, what really troubles critics is that economics is supposed to be based on proven laws, which is why banks and pension funds use its findings to forecast market movements, and governments trust it to direct monetary and fiscal policies. Imagine a group of physicists arguing about what would happen if a brick was tossed in the air. That’s the state of economics today. Which is why making macroeconomic policy is starting to look less like a skilled attempt to hit a baseball and more like a football Hail Mary pass.

And that brings us back to Cooper. A woman who began her career in Washington working for the Fed, Cooper used the announcement of her Klein Award selection as an opportunity to issue a forecast for 2011. According to the Oracle of BMO, “moderate growth will slowly gain momentum” in the United States while unemployment will “edge downward” to 9% and inflation will remain “muted.” As for interest rates, Cooper says they will “rise only moderately.”

Sounds good. But don’t bet your life savings on Cooper’s infallibility. After all, she admits that she based her projections on the expected positive impact of quantitative easing and federal stimulus.