Friday, June 15, 2007

Learning from the past

Why are economists so bad at forecasting?

As I mentioned before, economists need to make assumptions about the future in order to forecast.

Unfortunately, these assumptions tend to be wrong, as do their forecasts, which is why forecasts tend to be revised on a regular basis.

But I've come to realise that bad forecasting is also the result of looking at what happened in the past and failing to learn from it in a way that will help and not hinder predicting what could happen in the future.

While we are used to hearing that "the past is no indication of future performance", it is still possible to glean from past data critical information that will help in making a forecast more accurate and less prone to revisions.

Economists fail to take away the right information from past observations and keep making the same mistakes over and over again.


So, how can the past help us to predict the future? It depends on how you look at what happened.

Imagine you travelled down a road at 8am and it becomes very heavily congested. Based on what you have observed, you might also expect that if you travel down the same road tomorrow at 11am then it will be congested again.

Of course, this fails to take account of the fact that before 9am the road is unusually congested, since it's in the middle of the rush hour.

Economists make a similar mistake when using past observations to help forecast the future path of the economy.

They tend to look back at what actually happened rather than at what caused it to happen. In other words, economists look back at backward-looking data to help predict the future!


In trying to predict a recession it would be better to look at what leading indicators were doing in the run up to previous recessions and compare this to what they are doing now.

Instead, economists look at what happened to GDP, unemployment and inflation, which give no indication about the future, to predict what will happen to GDP, unemployment and inflation!

Part of the reason why economists don't use leading indicators is because they don't trust their accuracy. Currently, the OECD and Conference Board produce the most widely-followed leading indexes but these have had a poor record at predicting recessions.

Another reason why economists are sceptical about leading indexes is because they don't fully understand how to accurately construct one of their own.

A lot of work has been done in this area by my former employers at ECRI and you can follow some of their leading indexes in the press. However, since they are a private firm only a small amount of information is made public. This is unfortunate, since they have a pretty decent record at predicting turning points and in particular, the timing of recessions.


The fact that economists make bad forecasts is not necessarily a problem (they can be useful in other ways too!). However, financial markets look to economists, either in the private sector, government or at central banks to guide expecations about the future. If these expecations prove to be inaccurate or plain wrong then stock and bond markets will be unecessarily volatile. In reality, this is what we observe.

Trying to understand what caused something to happen in the past can help predict what is likely to happen in the future.

It would be like saying that a road (economy) that becomes heavily congested (has very high gasoline prices) at 11am (when leading indicators are stronger) will be better able to deal with that congestion (avoid a recession) than a road (economy) that becomes heavily congested (has high gasoline prices) at 8am (when leading indicators are weak).

Wouldn't it be better if we could assess the future of the economy with as much clarity as congestion on the roads?

Sunday, June 10, 2007

Go fishing

It's not unusual to hear people complain about the rising cost of living.

Our grandparents and parents have seen a rapid increase in the cost of living throughout their lives.

But that was just the beginning. They could never have anticipated what would come next.

What was affordable to our parents is unaffordable to many of us now: buying a house, driving a car, going on holiday, even buying a cup of coffee.

What some might consider fundamental to living a 'normal' life has now gone beyond the reach of the average person.

How it became this bad has already entered the mainstream media: developing countries such as China and India have been using natural resources so intensely that it has pushed up the price of everything that developed countries use every day.

What is not often discussed is what this 'new world' will mean for the lifestyle of millions, if not billions of people all over the developed (i.e. rich) world.

As I mentiond, a rise in the cost of living is nothing new.

The process of industrialisation and technological change has improved everyone's standard of living.

But this improvement has always come at a price.

After all, any rise in the cost of living is an inevitable by-product of an improving standard of living: we all need to want more to be willing to pay and hence justify its production.

This is simple supply and demand, as illustrated in my nifty little chart below:

The price of growth

What this chart shows is the rapid and increasing cost of living seen over the past 100 years or so.

Over that time, whenever there was an improvement in the standard of living and an accompanying rise in the cost of living, there was always an increase in demand (D,D',D''' etc.) to match the increase in supply (S, S', S'' etc.).

This process has accelerated in the past 10-20 years, especially with the rise of computer technology and globalisation. Note the chart does simplify a trend (after all, there could arguably have been a fall in the cost of living line over some periods, although the trend is certainly up), but it still manages to capture the current problem: a rise in the cost of living that has created a mis-match between supply and demand.

What this means is that the current increase in the supply of goods and services has not, and will continue to not be matched by an equivalent increase in demand. (Note: this is the case for developed countries)


So, what does all this mean?

In reality, quite a lot.

Firstly, substitution.

Instead of buying houses, people will rent. Instead of driving cars, people will use public transport. Instead of going to Starbucks, people will bring a flask to work or just drink water (from the tap!).

Secondly, people will change their lifestyles.

In the chart, any increase in demand that matches the increase in supply has an associated "sacrifice" that must be made.

Once people decide that the necessary sacrifice is not justified, or affordable, they will opt for a different way to use their free time and spare cash.

One option might be to go fishing.