Sunday, November 27, 2011

Federal Reserve Admits It Was a Complete Failure in Forecasting the Great Recession

This is big. Simon Potter, Executive Vice President and Director of Economic Research, Federal Reserve Bank of New York, is out with a post admitting that the Federal Reserve had no clue about the approaching Great Recession.

Here is Potter in his own words:
The economics profession has been appropriately criticized for its failure to forecast the large fall in U.S. house prices and the subsequent propagation first into an unprecedented financial crisis and then into the Great Recession. In this post, I examine the performance of the forecasts produced by the economic research staff of the Federal Reserve Bank of New York (New York Fed) over the period 2007-10 and consider some of the reasons why we, like most private sector forecasters, failed to predict the Great Recession...

The staff forecasts of real activity (unemployment and real GDP growth) for 2008-09 had unusually large forecast errors relative to the forecasts’ historical performance, while the forecasts for inflation were in line with past performance. Moreover, although the risks to the staff outlook were to the downside throughout this period, it wasn’t until fall 2008 that a recession as deep as the Great Recession was given more than 15 percent weight in the staff assessment...

...the New York Fed research staff forecasts, as well as most private sector forecasts for real activity before the Great Recession, look unusually far off the mark...

Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank’s economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out:

Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach [2004] and Himmelberg, Mayer, and Sinai [2005]). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.

A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff report by Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently...
It is curious that Potter only references a Keynesian when identifying those who warned about the crisis, and not the many Austrian economists who did so:
Indeed, in the period leading up to the financial crisis, analysts who were suspicious of the stability of the Great Moderation, such as Nouriel Roubini, offered assessments that proved to be significantly more accurate than the point forecasts of New York Fed research staff or most professional forecasters in gauging the potential for unlikely bad outcomes.

Quite interesting is that Potter cites the McCarthy and Peach failure to recognize the developing housing crisis. I responded to the McCarthy and Peach when it was written. At the time, I replied::

...the record climb in housing prices is, indeed, a bubble... the Federal Reserve study fails to consider past declining interest rates as a cause of the bubble. The faulty conclusions reached by Federal Reserve economists Jonathan McCarthy and Richard W. Peach may make many potential new home buyers comfortable about a purchase, when, in fact, we are very near the top of a housing market that will experience substantial declines in prices...

They reach the conclusion that because of ....[the] "fundamental factor" of low nominal interest rates, higher housing prices are justified.

But does this mean real estate prices will not drop? Our answer is decidedly no. Indeed, McCarthy-Peach report that "since 1995, real home prices have increased about 36 percent, roughly double the increase of previous home price booms in the late 1970's and late 1980''s." We view this increase as largely the result of the Federal Reserve's lowering of interest rates and the pumping of liquidity into the banking system, thus producing the byproduct of higher housing prices. But by incorporating falling nominal interest rates as a "fundamental factor" that can not be a cause of a bubble, McCarthy-Peach have literally defined the cause of the current bubble from being taken into consideration....

Further, the current structure of many mortgage loans whereby no money down is acceptable and/or adjustable rate mortgages are popular, sets up the possibility that many may walk away from current mortgage commitments down the road as interest rates begin to climb. Indeed, as ARM's rates become more and more burdensome and as housing prices begin to decline, walk away situations are likely to become quite prevalent, thus adding even more downward pressure to the housing market.

It is our conclusion, then, that by defining nominal interest rates as a fundamental factor and not as the Fed induced causal factor of the real estate boom, and by completely ignoring the structural features of current mortgage loans, McCarthy and Peach have blinded themselves to the real estate bubble that does exist. They have set themselves up for perhaps making the worst economic prediction since Irving Fisher declared in 1929, just prior to the stock market crash, that "stocks prices have reached what looks to be a permanently high plateau."
At the time, apparently, McCarthy and Peach thought my reply was funny and included this quote from me, in their power point presentation, when they went around the country declaring there was no housing bubble. Under the headline "Opposing View", they would flash this quote from my reply to their view:
The faulty analysis by Federal Reserve economists McCarthy and Peach may go down in financial history as the greatest forecasting error since Irving Fisher declared in 1929, just prior to the stock market crash, that stocks prices looked to be at a permanently high plateau.
I'm sure, at the time, it created quite a chuckle. But, this is the only known case of Fed economists responding to a Fed critique from a blogger. They clearly picked the wrong blog post to respond to. As I have said before, they aren't using that power point presentation anymore.

That wasn't my only warning about the real estate crash. I also wrote An Ex-Girlfriend, a Construction Worker and My Landlord and A Letter to a Friend on the Logic of Real Estate Investing.

Further, Potter notes that the Fed did not give a serious weighting to a recession until, at the earliest, the Fall of 2008. Throughout the summer of 2008, I was screaming that a  serious crisis was coming:

 I wrote in July 2008:

After growing at near double digit rates for months, money growth has slowed dramatically. Annualized money growth over the last 3 months is only 5.2%. Over the last two months, there has been zero growth in the M2NSA money measure.

This is something that must be watched carefully. If such a dramatic slowdown continues, a severe recession is inevitable.

We have never seen such a dramatic change in money supply growth from a double digit climb to 5% growth. Does Bernanke have any clue as to what the hell he is doing?
Again in July 2008, I wrote:
I have previously noted that over the last two months money supply has been collapsing. M2NSA has gone from double digit growth to nearly zero growth .

A review of the credit situation appears worse. According to recent Fed data, for the 13 weeks ended June 25, bank credit (securities and loans) contracted at an annual rate of 7.9%.

There has been a minor blip up since June 25 in both credit growth and M2NSA, but the growth rates remain extremely slow.

If a dramatic turnaround in these numbers doesn't happen within the next few weeks, we are going to have to warn of a possible Great Depression style downturn.

In August 2008, I wrote:

After growing at near double digit rates, Fed money supply growth over recent months has slowed dramatically. Three month annualized M2NSA money growth is at 2.8%. If money growth remains this low we will be in a recession in no time.
On September 4, 2008, I wrote:
ALERT: MUST READ Money Growth Plunges To 1.8%

The M2 money supply growth rate continues to plunge.

Data released today by the Fed show the annualized growth rate for the thirteen weeks ending August 25, 2008 for M2 is now at 1.8%. As we have emphasized, this is after early 2008 M2 money supply growth at double digit rates.

If the Fed doesn't reverse engines real fast, the economy will plunge into Depression-like conditions within months, if not weeks.

Extreme caution should be exercised with regard to all long term business decisions. Within six months the economy could look much different. Preserve cash.
I am going to contact Potter to see why he did not acknowledge the warnings of Austrian economists in his report. Especially his failure to acknowledge me, when the Fed was perfectly willing to get a chuckle, via a slide presentation, over my forecast, when I warned that McCarthy and Peach had no clue, and at the time, McCarthy and Peach did not believe for a minute that I was accurate.

Potter's post takes a great step in acknowledging the great failure of McCarthy and Peach and the overall Fed failure in seeing the crisis. Let's see if he will be willing to acknowledge that those using Austrian Business Cycle Theory were way ahead of the Fed in understanding the dangerous situation the Fed set up for the economy.


  1. This probably is just a misinterpretation, but it sounds like you were asking at that time (July-Aug 2008) for Bernanke to start inflating again. You agree that the recession was inevitable and that if he decided to "reverse engines real fast" we would have just had more inflation, correct?

  2. Excellent post. It is funny to read that their admission of error includes "most private sector forecasters." But, we shouldn't be too hard - it can be very difficult to admit when you are wrong and their admission is a step toward "recovery." Maybe their next admission will be that their very existence is more harmful than good - maybe it could be based on an analysis of price "misalignment" and misallocation of resources?

  3. @intellectuallyliberated

    You need to read EPJ regularly. I consistently point out that the Fed should not be in the business of manipulating the money supply.

    That said, there are many readers who come to EPJ who are investors looking to get guidance on how to invest, rather than theoretical discussions on what a perfect world might look like. In that sense, the view taken by me in the posts above was to point out exactly what was happening at the time, which was Bernanke was crashing the economy. Such guidance, I think, might have been helpful to investors.

  4. He's Lying.
    The terrorists are just trying to make themselves less hated. They did this on purpose to further the New World Order just like 1929 with Roosevelt.

  5. This is great article. Thank you. We would be interested in your take on the YouTube video which can be found at youtube by searching: "Dylan Ratigan - INTENSE TRUTH with MAINSTREAM Media." It is disturbing and on point of your article. What is disturbing is Ratigan uses the word or phrase the "united States is being extracted." He is referring to the currency being exported and remaining out of country and ostensibly unavailable to all Americans. Do you have any understanding of what Ratigan means by " being extracted" ? Also, it it your understanding that insurance and reinsurance US dollar based "reserves against losses" being help by insurance and reinsurance companies in Bermuda and Switzerland are currency which is also ostensibly unavailable to Americans for everyday transactions and needs? Many thanks.

    Here is a link to the video:

  6. I got it, was just confirming, thanks for the reply :)

  7. "It is curious that Potter only references a Keynesian when identifying those who warned about the crisis, and not the many Austrian economists who did so"

    Because Austrian "economists" are political/moral philosophers, not economists. Economics went from a moral philosophy to a science over 200 years ago but nobody told any of the Austrians.

    By the way, predicting recessions in a non-mathematical/scientific way are not impressive in the least. Nobody- especially not you- could meaningfully tell me that it's hard to sit in a room with a computer and be a bearish, douchebag blow-horn all day long.

    Austrian moral philosophers are the queens of cooking up a big pot full of bullshit, flinging it at the wall, and seeing what sticks. Yet, I have never heard one of them make a more accurate prediction than a monetarist, or keynesian. In fact, the market for doomsday predictions that the Austrian queens love oh-so-much is pretty much perfectly competitive; there are many idiot economists of all flavors and stripes predicting recessions and the fall of society.

    Austrian theory has never been able to predict the timing and severity of a crisis. They might say "ooooooooh yaaaaaaaah I tink a bigg'un recess'un be comin soooooooooon!" or "oooooooooooh yaaaaaaaaaah we gots a recess'un comin' dis nex' yeeeeeee'!!"

    In all seriousness, the general "theory" they operate under is not a true cohesive theory at all. It's a bunch of flimsy assumptions untestable by any measure. A priori assumptions are not intellectually robust, nor do they demonstrate understanding of anything. Assumptions based off of measured observations might only hold true 99.9% of the time, giving you uncertainty, but the uncertainty itself is measurable as well! Such scientific assumptions do, on the other hand, demonstrate a working understanding of general relationships that exist in the world.

    The best part about this, Wenzel?

    You have proven me right. Totally vindicated my attitude of looking down on Austrian thinkers.

    Your childish, ignorant little doomsayings reveal no true knowledge of jackshit. You can never tell me when the recession will happen. All I hear from you;

    "...we are going to have to warn of a possible Great Depression style downturn."

    "If money growth remains this low we will be in a recession in no time."

    "If such a dramatic slowdown continues, a severe recession is inevitable."

    Are these not the very types of hilariously ignorant and empty doomsday prophecies I caricatured earlier in my post? Did you not just spew hot air all over your sad little blog, providing us with exactly zero useful information about the timing and magnitude of "crisis X?" Mind you, the words "severe" and "might be like the great depression guys" do not constitute defining magnitude. It's you using the same words you used in high school.

    Thanks, Wenzel. As usual, it's been lots of laughs hearing the nonsense from the philosophy department of economics. They say there's no such thing as a free lunch, but you've given me enough fodder to feed the cannons for at least a month.

    By the way, before any of you geniuses thinks of writing off this brick of fact as "ad hominem," I recommend you go back to Wikipedia where you all first learned what that term meant, and re-read the difference between an ad hominem argument, and a logically coherent argument where I call you an idiot at the end, after disproving your pathetic point.

    Have a great day.

  8. In other news, the Federal Reserve Admits It IS a Complete Failure...

  9. @anon 10:23

    Geez, someone is a little upset. I guess Wenzel is supposed to be God and predict exactly how much "damage' the downturn would do as if that is even possible.

  10. Wenzel is a complete failure as an economist, as are all Austirans, even the ones with names I can't pronounce.

    Wenzel was unable to predict which banks would fail, and on what day, and he had no idea what those banks were serving in their cafeterias.

    Even though he and several other Austirnas were able to predict to within a month or so the collapse, and Keynesians were totally unaware of the looming crash, and are STILL unaware of the cause, Austrians are not real economists because they aren't and their theories are crap because I probably haven't read them, much less understood them.

    /sarcasm off

    Thanks to Bob Wenzel, Pete Schiff, Gary North, and Tom Woods, I still have a 401k, a safe with some shiny stuff in it, and a house. And no debt beyond a mortgage.

    Pretty accurate forcast... At least good enough for government work.

  11. @anon 10:23

    No offense but your comments are the prime example of idiocy.

    Besides all nonsense you wrote there is this gem 'providing us with exactly zero useful information about the timing and magnitude of "crisis X?"'

    That seems to indicate your world view that the economy is ok and then suddenly a "crisis" happens out of the blue! And of course you think well this is a phenomena of nature and must be predicted with some sort of physical law.... You obviously know how to spell like an adult but why do you still think like a kindergarten child?

  12. Got his undies in a bundle - all stuffed with fiat currency and cutting off the blood supply to his brain. Go long big fella. Sell metals and trust your government, after all, they have your best interest at heart.

    P. S. Careful you don't choke to death on your hubris and condescending attitude. Oh, and tune up that fiddle, we are going to need some good music as Rome burns...

  13. Texas Chris,

    Let's not forget these crappy little contributions!

  14. anon 10:23,

    One of the most important parts of Austrian theory is that no one can fully know or plan how an economy works, or what the full repercussions of policies regulating it will be. That's why mainstream economics is so full of hot air. There are causes and effects, but as far as trying to put numbers to it and make predictive models with exact figures, you'd be better off talking to a fortune teller.

    I received my mainstream economics education at a state university before I discovered Austrian thought, so you can be assured that I learned what 'ad hominem' means in a philosophy class (though I've later had to refresh and expand my knowledge using Wikipedia).

    Perhaps you didn't see the link to Walter Block's incomplete list of Austrian-minded thinkers who called the Housing Bubble:

    Sure, some of em were calling it in 2001, and some, like Wenzel continued to call it right up to July 08. Does it make them wrong that they were not able to name an exact calendar day? They certainly called it better than the Fed economists cited in this article, who not only did not see the crash coming, but laughed at those who said it was. The best that economics can do, examine the causes and effects.

    The dollar as the world's reserve currency certainly won't last forever...but will it end next month or in 10 years? I don't know. Will the first country to leave the eurozone do so in December of this year or next year? No amount of equations and graphs can tell you what a mass of human actors will choose to do. The study of economics is the study of human action, which is unpredictable.

  15. Anonymous@10:23

    "A priori assumptions are not intellectually robust."

    Keynesianism is based on a priori assumptions.

    In fact, positivist epistemology itself is based on a priori assumptions, namely, the a priori assumption that the truths of reality do not change over the course of time. For that is the assumption that must be made if one is to conclude that theories proposed in the past have been confirmed or falsified in the present.

    Considering your idiotic post, you are clearly not intellectually qualified to judge Austrian economics. You're just parroting talking points you heard that make you feel psychologically relieved, because you want to believe that "science" invariably leads to advocating for state intervention into the free market economy.

  16. I get so tired of all this bickering and name-calling back and forth like a bunch of school kids fighting on the blacktop. I can't even invest time reading and learning other people's opinions without it digressing into a verbal gang fight like a bunch of drunk fans at a European football game. Do any of you juveniles recognize the fact that it does not solve our issues when we call each other names and hurl insults at one another? I submit to everyone on this blog that our problems are not economic, political, or even moral. Our problem is there isn't any more love in this country. We've abondoned anything that even remotely resembles love for our country and our countrymen. There is so much contempt. Why? Why aren't you mature enough to disagree without all the venomous hissing and spewing at each other. You all think you're big chest-thumping silverbacks vying for supremacy of the mountain top when really you're just a bunch of rabid sewer rats biting off your own tails. It gets old. Grow up and learn the meaning of civil discourse. You might actually accomplish something in your lives.