Monday, May 14, 2018

How to Forecast the Economy

Henry Kaufman
By Robert Wenzel

In the late 1970s, Henry Kaufman was tagged with the nickname "Dr. Doom," when he was the chief economist at Salomon Brothers, because of his dire warnings about government economic policies, especially large deficits and what they would do to the bond market. His comments could move markets back then and justifiably so, he was largely correct.

Most notable, though, he turned bullish on the stock market on  August 17, 1982, when he accurately predicted the stock market had bottomed. His bullish turn that day led to a huge rally in both stocks and bonds that was the beginning of the longest bull market in history.

In 2016, Palgrave published the Henry Kaufman book, Tectonic Shifts in Financial Markets: People, Policies, and Institutions, it is part memoir, part financial history and part commentary on how to understand the economy.

Kaufman provides no indication he is
familiar with the Austrian school of economics (though he mentions Hayek twice in the book) but he is highly suspicious of most forecasting work done by econometricians and he warns about big spending government, both positions that Austrians can certainly applaud.

There are no step by step instructions of how to properly put a model of the economy together in this book but his grand observations would be extremely valuable to anyone who plans to attempt some type of economic forecasting---even of the most general kind.

A taste from the book:
[T]he critical ingredient in making good projections often is the ability to understand what differs from the past.
As opposed to just extrapolating a current trend.

He also quotes Gene Guill on Bankers Trust and the birth of modern risk management:
One of the biggest dangers with models is that users may arise [who do not] challenge them, by failing to question their assumptions, their parameters, and their specifications. Over time variables and relationships that were originally thought to be significant or simply ignored may become highly significant and the model itself may produce misleading results.
But there is much more in this book than warnings about economic models. There is wise counsel about the way the world works:
Perhaps presidential preferences [about Fed policy] are conveyed through operatives; certainly they are no longer public.
The decision by key government officials to let Lehman fail was heavily influenced by politics.
And there is great history about the Federal Reserve and economic policy in general and Kaufman knows how to tell a story:
The most amusing confrontation with President Johnson was actually told to me by Bill Martin after he retired from the Fed. He had been called with great urgency to come over to the White House to meet with the president. The chairman rushed over rather fearfully, not knowing what to expect. The president saw him in the Oval Office. He then told Martin to hold in great confidence what he was about to say. With that the president stood up, dropped his pants and said roughly, "Now Bill I am going to have an operation around here (pointing to the lower part of his body), and you aren't going to raise interest rates while I am temporarily incapacitated, are you?'
Kaufman knows both Paul Volcker and Alan Greenspan. He gives Volcker high marks for his running of the Fed, not so much for Greenspan:
Within the Fed, too, Paul opted to do the right thing as he saw it, rather than striving to win a popularity contest akin to what Alan Greenspan did while he was Fed chair. In order to push through his anti-inflation policies, Paul had to overcome contrary views within the Board of Governors. The initial vote to raise the discount rate passed by a mere four to three.
The great financial history and great observations in this book make this book one that every trader and econometrician should read. It should also be read by anyone who just enjoys a good telling of financial policy history of recent decades.

The above originally appeared at the San Francisco Review of Books.

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