Economists Have No Clue About the Future

In November 2008, as stock markets crashed around the world, Queen Elizabeth II visited the London School of Economics to open the New Academic Building.

While being there, the Queen, who studiously avoids controversy and rarely reveals what she’s actually thinking, finally asked a question:

“How come nobody could foresee it?”

No one could answer her.

They are no better at forecasting than anyone else

Central banks tell us they know when to raise or lower rates, when to resort to quantitative easing, when to end the current policies of financial repression, and when to shrink the bloated monetary base.

However, given their record at forecasting, how will they know? The Federal Reserve not only failed to predict the recessions of 1990, 2001, and 2007; it also didn’t even recognize them after they had already begun.

Financial crises frequently happen because central banks cut interest rates too late or hike rates too soon.

The central banks tell us their policies are data-dependent, but then they use that data to create models that are patently wrong time and time again. Trusting central bankers now, whether in the US, Europe, or elsewhere, is a dicey wager.

Unfortunately, the problem is not that economists are simply bad at what they do; it’s that they’re really, really bad. They’re so bad that their performance can’t even be a matter of chance.

Just look at the consensus forecasts of Wall Street analysts over the last few decades.

Wall Street strategists vs. the Blind Forecaster

The chart below show’s Wall Street’s consensus S&P 500 forecast versus the actual performance of the S&P 500 for the years 2000–2014.

The remarkable thing here is that forecasters seemed to pay zero attention to recent experience. Upon finishing a bad year, they forecasted a recovery. Upon finishing a good year, they forecasted more of the same.

The only common element is that they always thought the market would go up next year.

Morgan Housel of The Motley Fool went further and measured the Street’s strategists against what he calls the Blind Forecaster. This mythical person simply assumes the S&P 500 will rise 9% every year, in line with its long-term average.

Housel calculated that the strategists’ forecasts were off by an average 14.7 percentage points per year. His Blind Forecaster, who simply assumed 9% gains every year, was off by an average 14.1 percentage points per year.

The Blind Forecaster beat the experts even if you exclude 2008 as an unforeseeable “black swan” year.

It isn’t just Wall Street that wears rose-colored glasses.

Fed’s GDP forecasts vs. actual growth

All right, so if forecasting the stock market is harder than it looks, how about forecasting the economy? Surely the Federal Reserve has a good handle on future growth prospects.

If that’s what you think, prepare to be disappointed.

Here’s a chart showing Fed’s forecasts for 2011–2013.

The colored lines show you how the forecast for each year evolved from the time the FOMC members initially made it.

As of October 2009, FOMC members expected 2011 and 2012 would both bring 4% or better GDP growth. Neither year ended anywhere near those targets.

Their initial 2013 forecast was near 4% as well. They reduced it as the expected recovery failed to materialize, but as in 2009, they actually guessed too low.

Government economists are about as useful as a screen door on a submarine. Their mistakes and failures are so spectacular you couldn’t make them up if you tried.

Yet now, we trust the same people to know where the economy is, where it is going, and how to manage monetary policy.

Their models are too simple to predict the future

The underlying reason for this mismatch is that economists base their models on flawed economic theories that represent at most a pale shadow of the true economy.

They assume they can use “dynamic equilibrium” models to describe and forecast the economy.

In order to create such models, they have to make assumptions — and when they do, they assume away the real world.

It is not so much that the models I am criticizing are useless — they can offer economic insights in limited ways — but they cannot (successfully) predict the economy or stock markets with anything close to certainty.

The models we are using are not complex enough — and they cannot be made complex enough — to accurately describe the nonlinear natural system that is the economy.

Such models can at best give you insights into certain conditions that are limited by the assumptions you have to make in order to create the models.

If you’re using your models properly, you understand their deep limitations. I freely admit to using models to gather as many insights as I can (especially about relative valuations), but I certainly don’t rely on them to actually predict the future.

You should never use a model without understanding in a deep and all-encompassing way that past performance is not indicative of future results.

I’m concerned that, in the coming years, looking at historical data for guidance about the future will be more misleading than simply guessing would be.

The times aren’t just changing; the very underlying economic conditions that produced past performance will no longer pertain.

But they need someone to take the blame

So if you think Wall Street, the Fed or government agencies know what is going on with the economy, think again.

Investors want to believe that certainty is possible, that crunching the right numbers or listening to the right guru will reveal what lies ahead.

The idea that markets are inherently messy and disorderly frightens them. It’s much more comforting to think that someone out there has a crystal ball that you just haven’t found yet.

But the reality is that no one knows what’s coming and when. Most forecasts are just blind assumptions based on flawed economic theories, which — as we’ve seen — are no better than historic averages.

I think what many investors really want is a scapegoat.

After all, the only thing worse than being wrong is being wrong with only yourself to blame.

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