Economists. What are they good for?

The American economist Dean Baker has a nice article this week titled How Many Economists Does it Take to See a $8 Trillion Housing Bubble?

The answer to that question has to be many more economists than we have in the United States. Very few economists saw or understood the growth of the $8 trillion housing bubble whose collapse wrecked the economy. This involved a degree of inexcusable incompetence from the economists at the Treasury, the Fed and other regulatory institutions who had the responsibility for managing the economy and the financial system.

There really was nothing mysterious about the bubble. Nationwide house prices in the United States had just kept even with the overall rate of inflation for 100 years from the mid 1890s to the mid 1990s. Suddenly house prices began to hugely outpace the overall rate of inflation. By their peak in 2006 house prices had risen by more than 70 percent after adjusting for inflation. Remarkably, virtually no U.S. economists paid any attention to this extraordinary movement in the largest market in the world.

Had they bothered, they would have quickly seen that there was no plausible explanation for this jump in prices in either the supply or demand side of the market.

Does any of this sound familiar? To some of us it is equally baffling that having watched what has happened in the United States and many other countries, economists at Treasury, the RBA and all the Australian banks continue to tell us that there is nothing at all to worry about in Australia.

Maybe they're right. But wouldn't it be nice if they at least pointed out some of the risks? In any case, next time you read an economist's prediction in the newspaper, keep in mind that most of the time, at least when it comes to predictions about the future, the experts don't have a clue what they're talking about. And they are especially bad at predicting when things might go wrong. As James Montier of the fund manager GMO said recently:

Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Exhibit 4 (see below) reveals that economists are simply useless when it comes to forecasting. They have missed every recession in the last four decades! And it isn’t just growth that economists can’t forecast: it’s also inflation, bond yields, and pretty much everything else.

Source: GMO

Like any other profession, there are plenty of smart people in economics. So why are economists so incredibly useless when it comes to forecasting? As Dean Baker notes in the article above, if you were looking in the right place, it wasn't hard to see that there was a major housing bubble developing in the USA in the years of 2000 to 2007, but hardly anybody raised the alarm. Here are a few possible explanations that come to mind:

• Some events that impact the economy are impossible to predict; for example, the recent floods in Queensland or the 9/11 attacks. 
• In every single financial bubble in history, there has been an argument that "this time is different" -- from the Dutch tulip mania of the 1600s to the Japanese "miracle economy" of the 1980s to the recent US housing bubble. These arguments often sound plausible at the time, but are later shown to be rubbish. Even very smart economists get caught up in the euphoria.
• It's not easy being a contrarian. If you forecast doom, and get it wrong, you look like a fool. If you forecast a continuation of the status quo and get it wrong, well, at least you can take comfort in the fact that you got it wrong along with everyone else. If you forecast doom and get it right, you may not get that much thanks because some people will want to "shoot the messenger".
• The economists that are most prominent in the media (mostly from banks and real estate companies) are generally paid to be bullish in order to drum up business. Do you really think an economist at an Australian bank is ever going to forecast a crash in the housing market when their profits are so dependent on massive issuance of mortgage debt? (and if you think academic economists are completely free of conflicts of interest, go see Inside Job).

Now, I'm not sure if any of the above apply here, but recently Craig James of CommSec got a bit testy in response to the argument by some contrarians that Australian house prices might be a little overheated. (Delusional Economics wrote about this here).

"There hasn't been any evidence that there has been a housing bubble and none to suggest that one is likely," James says. "Some commentators make inaccurate and damaging comments about housing bubbles and affordability without facing consequences. While it may be an emotive story, inaccuracies can limit housing investment and prevent supply from adjusting to higher demand."

It might just be my imagination, but Mr James sounds a little defensive.

In any case, it's not easy going against the flow. David Rosenburg, a highly respected American economist who is now at the Canadian investment firm Gluskin Sheff, recently spoke about how lonely it was being one of the few pessimists during the market rally in 2003-2007, when he was chief economist at Merrill Lynch, whose corporate symbol was a bull.

I recall all too well that 2003-07 bear market rally — yes, that is what it was... It was a classic bear market rally, and did last five years. I was forever skeptical because what drove that bear market rally was phony wealth generated by a non-productive asset called housing alongside widespread financial engineering, which triggered a wave of artificial paper profits. I knew it would end in tears … sadly, I didn’t know exactly when. I was constantly defensive in my investment recommendations at the time and there was a huge price to be paid for being bearish when there is a bull on your business card, trust me on that one.

That's it for today. Next time, we'll take another look at China, the commodity price boom and Australian house prices. Just remember that I don't know what I'm talking about either...