Sunday, March 28, 2010

Why Greg Mankiw Will Never Make a Major Accurate Economic Forecast

Harvard Prof. Greg Mankiw has a particularly absurd column in NYT this week. He doesn't understand business cycle theory, so anyone that did forecast the downturn, according to him was just lucky:

Perhaps the best place to start is to acknowledge what we cannot do. If recent events have taught economists and policy makers anything, it is the need for humility.

One thing we cannot do very well is forecast the economy. The recent crisis and recession caught most economists flat-footed. This is nothing new. We have never been good at foretelling the future, but when the news is favorable, others forgive our lack of prescience.

Some critics say the Federal Reserve should have foreseen the bursting of the housing bubble and its financial aftershocks. A few of them, having made the correct call themselves, are enjoying new found celebrity.

Yet at any time, there are many forecasters with a large range of views. After the fact, a few will turn out to be right, and many wrong. Policy makers at the Fed don’t know in advance who will be the lucky few.
When I pointed out the flaws in the 2004 Federal Reserve analysis about the housing bubble, I don't think luck had anything to do with it. My analysis was simply solid. I invite Prof. Mankiw to explain why this analysis was luck versus better analysis than that of the Fed.

Specifically, in 2004, New York Federal Reserve economists Jonathan McCarthy and Richard W. Peach wrote a paper Are Home Prices the Next Bubble? Their answer was decidedly, "No".

I issued a reply to their paper, at that time writing under a pen name because of other business commitments:

...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, 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."

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 me:

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.
Last I heard, they aren't using that power point presentation anymore.

These calls, despite what Mankiw thinks can be made quite regularly.

Here at EPJ, in August of 2008, just before all hell broke loose, I could not have been more clear that the crashing housing bubble was going to turn into much more:

Only a much lower interest rate would reverse the current situation, or perhaps non-sterilized loans and purchases of bank collateral provided by those using the Term Auction Facility. If this isn't done soon then the economy and stock market will worsen by leaps and bounds, including a major eye opening stock market crash.
Pre-internet I also called the 1987 stock market crash. I called the bull run in gold from the bottom. I called the current weakness in gold. I called the strength in the dollar. The list goes on. I consider this record the result of my understanding economic theory and financial markets. I always have a logical explanation for my forecasts. It is not luck. Just because Mankiw can't do it, doesn't mean it can't be done based on analysis. In fact, I have a pretty good idea why he will never make a major accurate forecast.

1. He operates out of a flawed Keynesian perspective, which means there are few macro-structure failures that he will detect. But this in itself shouldn't prevent him from making the obvious forecasts.  Nouriel Roubini is a Keynesian, but he watches the data close enough to make many accurate forecasts. Paul Krugman, who is clueless as far as theory (see here) is actually decent as far as knowing where the economy is.
To be fair, my warnings about the housing bubble, and those of Roubini and Krugman, were not that difficult to make. When you are making no money down mortgages with exploding interest payments that problems were going to hit the fan should have been obvious to any economist who understood the word default. You just needed the courage of your convictions to say the obvious, which brings me to Mankiw's other great flaw.

2. He has a wimpy personality. If he even detected a structural flaw in the economy, he doesn't have the balls to stand out and say so clearly. He simply is afraid that it will somehow damage his reputation and ruin his chances at a cabinet post the next time a Republican administration rolls in to power. How could he possibly have warned of the dangers, if he even saw them, under the Bush administration. The major forecasts always come when you stand against the crowd, and you have to be bold and stand against political powers. Even Krugman gets this. (Notice: Krugman is "advising" the Obama administration fron the outside.) I really don't think Mankiw has it in him. He'd rather cast it off as luck when someone does make an accurate forecast, even though the real reason is that they don't suffer from the flaws that Mankiw does.

Greg, baby, it's not about luck. It's about having good theory on your side (Or at least good data, in the case of Krugman and Roubini) and the balls to say loud and clear what you see developing.

1 comment:

  1. Bob,

    Why is Mankiw so obsessed with this consensus-driven "Community of Economists" view of the world, in which he, surprise, is the leading spokesman for what the Community does and does not know about X or Y or even Z?