Economic Forecasts
By Richard P. Halverson

A friend asked recently, “Why is there so much disagreement among economists and why are they so often wrong?”

Perhaps the first question is to be asked is why should anyone be interested in economics? The following definition is helpful in understanding why.

ECONOMICS 1 : a social science concerned chiefly with description and analysis of the production, distribution, and consumption of goods and services.

Merriam-Webster On Line Dictionary

We all need certain goods and services to live, and most of us must produce goods and services to exchange for what we need. Which goods and services we get and how much of them we receive is matter of economics. Most of us want more than we already have even while there are many in the world that do not have enough.

Goods and services in the world are finite. There is only so much gold in the world, so much health care, so many cars, so many cruises, so many places in the classroom, etc. Exactly, which goods and services each of us will be able to consume during our mortal experience depends on many things such as: where we live, our heritage, our culture, our personal abilities, events in our lives, our families, etc. Government policy can influence our personal economy. Perhaps the most important component determining the economic outcomes in our lives is ourselves. Our own hard work, wise choices and discipline have a great deal to do with how much of the world’s scarce resources we are able to consume.

This brings me to the role of economists in the society. There are at least two reasons why you and I should pay some attention to what they say. First, a sense of the direction of the economy is helpful in making important personal decisions. Second, important institutions such as government and corporate employers listen to economists, and their decisions affect us.

The problem comes in what my friend asked, “Why is there so much disagreement among economists and why are they so often wrong?” What good does it do to pay attention to economic forecasts if the forecasts are unreliable?

Economic Forecasting Is Only an Educated Guess

Economic forecasting is not a science. In truth it is not even an art. Educated guessing is probably the best description. There are several serious difficulties economists face.

Hundreds of millions of economic decision makers. Every consumer whether rich or poor, every business large or small, and every government, public and charitable institution in the country represents an economic unit. They both produce goods and services and consume them. There are hundreds of millions of us. Each of us makes decisions based on what we perceive to be our own best interests. All an economist can do is try to predict how these hundreds of millions of individual decision makers will respond to various events. There is simply no human being or computer that can get inside the minds of all those individuals and accurately predict what they will do.

For example, assume government economists would like to slow the economy a little to avoid inflation. Economists might tell the Federal Reserve that if they raise interest rates a little the cost of home buying will increase and fewer homes will be sold. However, consumers might look at the interest increase and think, “I had better hurry and buy before rates go up anymore.” The economists are shocked to see housing sales increase rather than decrease.

Large numbers of random events. The problem of forecasting how consumers will respond is complicated by the fact that most events are seemingly random and occur outside the control of government policy makers. September 11^th is an extreme example. During the summer of 2001, the economy was showing solid signs of recovering from a brief recession. No economist could have predicted the attack that had an immediate and dramatic effect on people. Then after the attack there was wide disagreement by economists on how deep and long lasting the negative effects would be. Some predicted a depression. It wasn’t just the economists who were confused, no one knew.

Very imprecise tools. Most of us hear a news headline like, “The gross domestic product increased 3.5% last quarter.” Few of us realize that number will be revised many times in coming months before it is final. The gross national product numbers for last year are still being revised. The quarter you just heard reported may wind up at 3.0% or perhaps 4.0%. Who knows? This is a real problem if you are an economist trying to build this number into your economic forecasting model.

It gets worse for economists. Not only are the reported numbers constantly being revised — every once in awhile “they” will come along and completely redefine them. Imagine you are an economist. You just get your predictive model working using something like the consumer price index when they redefine the meaning of consumer price index. Now nothing going forward is really comparable to what was reported in the past. It happens all the time.

The tools are so imprecise it is difficult to know where we are, let alone where we are going. For example, I see comments on a daily basis about how poor the current economy is. In reality the economy has been growing steadily for nearly four years. Interest rates and inflation are low. But others point to the unemployment statistics that are still above an unsustainable level in the late 90’s, outsourcing and the price of gasoline and claim things are terrible.

We all make jokes about weather forecasters. But what if the weather tools were so imprecise that weather forecasters could not even tell you what the weather was yesterday — let alone use that to predict tomorrow?

Predispositions and biases. Because of imprecise measuring tools, random events and unpredictable behavior on the part of hundreds of millions of consumers it is nearly impossible to prove what actually happened and why, when it comes to economics. This means people can figure out a way to interpret events to fit their own personal preconceptions and bias. Take for example the hot button issue of taxes and their effect on the economy. One group feels the best way to stimulate an economy is to tax the highest earners and redistribute their wealth to the lowest earners. The theory is that the poor must spend every dollar just to live. Thus an extra dollar will be spent stimulating the economy. The rich, on the other hand do not need an extra dollar. Consequently, they many not spend it and this is thought to be less stimulative. Another camp argues that the rich invest their extra dollars and that investment capital is necessary for creating jobs for the poor. Additionally they argue taxes on the rich discourage them from working and being as productive as they might be to the great detriment of the economy.

So now that we have these two theories is there any actual history that can give us clues about which camp is correct?

When Bill Clinton became President the economy was just emerging from a recession. He responded by raising taxes to balance the budget and redistribute money. The economy expanded and was sound for most of his presidency.

When George W. Bush became President the economy was just sinking into a recession. He responded by cutting taxes putting more money in the hands of people to spend and invest. The economy expanded and has been doing fairly well since.

Two dramatically different approaches both seemingly leading to a good economy. So the debate rages. Those economists who believe in lower taxes look at the Clinton years and say, the economy was already improving taxes actually hurt and the real boom was caused by the Internet/technology explosion. Those economists who believe in higher taxes look at the Bush years and say the tax cuts have resulted in large deficits that are dragging the economy and that things would be going faster if tax rates were restored. The tax cut crowd responds by saying the economy was sinking fast when Bush cut taxes and given the speculative losses in Internet stocks should have plummeted further. Additionally, 9/11 and the wars have been setbacks. They argue the economy was saved by tax cuts.

It is like arguing about religion. It is beyond scientific proof. People in different camps can find all the anecdotal evidence they need to justify their beliefs.

Why Care?

So if economic prediction is so difficult should you care? Yes! It is important. Understanding the economy can have these positive benefits for you.

You will invest better.
You will make wiser financial decisions. For example the success of launching a new business making a job change or even buying a home can depend on the economy.
You can be better informed regarding such things as oil prices and interest rates leading to wiser decisions.

A Few Economic Truisms

Let me share with you a few truisms I have found relating to economic forecasting that may help.

· Understanding how ordinary people will respond to changing events is key to forecasting. This is tough. We all believe we are better than average in understanding human behavior just like we all believe we are above average drivers. I guess it is part of human behavior.

· People act in their own self-interest. This collective individual action is frequently contrary to the good of the economy as a whole. For example, if the economy starts down people spend less out of fear. However, spending is what is needed by the economy.

· People react with a crowd mentality influenced by what people around them are saying and doing. Spot the trend early and you can do well. Get caught up in the trend and you will do poorly.

· Everything in the economy is cyclical. Everything. If the cycle is up prepare for it to go down and vice versa.

· The economy is not a sum zero game. A rising tide lifts all boats. It is true that the swells and waves may bounce the boats around but on average they will all rise. It is not necessary for one person to lose in order for another to gain. A feeling that you are a victim and that others are getting ahead at your expense is destructive your productivity.

· Be careful what taxes and subsidies you support. Here is one economic principle that works every time. You get less and less of what you tax and more and more of what you subsidize. Tax productivity and subsidize laziness and you will get a less productive and lazier economy.

· Completely free markets do not work. Completely controlled markets do not work. Mankind does not yet have the wisdom to live with either. Something in the middle is best. The world has much experience with completely free markets with no central control. Feudalism might be an example. Eventually, everything is owned by a very small percent of the most powerful and all the rest suffer. The world also has much experience with completely controlled markets. Communism is an example. Communism was and still is a terrible economic failure everywhere it has been tried.

You Are the Most Important Variable In Your Economy

This closing thought is most important when it comes to ones personal economic fortunes. There are many events beyond our personal control that determine how each of us will do personally. However, no matter what our circumstances we can improve them through hard work, discipline and making wise choices. In the end each of us are the most important variable in our personal economic fortunes. The more you believe you are responsible for yourself the more economic progress you will make. The more you believe you are dependent on someone else doing things for you the less progress you will make.

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