When Forecasts Go Bad

Many people don't know that economics is really a social science; sure, there's a lot of math and stats involved, but they're only barometers to explain the behavior of people and markets. That's why the book Freakonomics was such a huge hit -- it helped explain the hidden meanings behind economic case studies (such as crack dealers living with their mothers) that at first glance didn't make sense.

The fact that economics is a social science is also why forecasts can go bad -- sometimes very, very bad. Writing earlier this month in Slate, author Daniel Gross (one of my favorite writers & commentators) argues that certain forecasts are inherently suspect:

...within the fraternity of financial and fiscal forecasters, the seers at the National Association of Realtors—longtime chief economist David Lereah and his successor Lawrence Yun—may be uniquely ill-equipped to deliver sobering forecasts. They work for a trade group whose mission is to buck up the spirits of real-estate brokers. And real-estate brokers—who live to sell, promote, and market—are constitutionally disinclined to hear anything but good news.

That's also why you might see similarly (relatively speaking) rosy forecasts from other trade group sources such as NAHB, although since their magazine, Builder, is licensed to be published by another company, Hanley Wood, the magazine can remain more objective. That's also why you might expect the CBIA to release bad news on a Friday afternoon in order to minimize coverage by the state's newspapers (sort of like when the White House declassifies documents on a holiday weekend).

These trade groups are in a tough spot: they don't want to anger those members they represent, and yet they want to be viewed as objective and appropriate news sources to the media, although Gross argues that NAR took it to the extreme:

Indeed, as I noted last summer, Lereah's penchant for putting out positive spin on dismal housing numbers inspired a blog and led critics to dub him the Baghdad Bob of real estate. Lereah has moved on. But Yun has picked up where he left off.

In addition to claiming that the sun is shining brilliantly even as rain pours down from the heavens in a mighty stream, Lereah and Yun have also hazarded optimistic, educated guesses about the future.

I think these guesses have really hurt the NAR's credibility as well as those of all real estate agents, many of whom are much more responsible with their clients when it comes to hazarding guesses about the future. Markets go up, markets go down, and there's always risk involved. Period.

So what about other economic forecasters? Why do they get it wrong? Several reasons according to Gross:

There are some institutional reasons for this: Many economists are associated with corporations, Wall Street firms, and trade groups, where it doesn't pay to be bearish. Others fall into the trap of extrapolating existing trends into the future. But given the complexity of the contemporary world, the huge range of variables, the unrelenting flow of data, and the fallibility of humans, it's likely impossible to forecast consistently with any accuracy. And it's especially difficult to project economic activity when the economy reaches inflection points—times when the economy is about to go from expansion to contraction, or vice versa.

Certainly relying on past patterns alone could allow a forecaster to ignore an inflection point. Writing in the New York Times, author Peter Bernstein offers a recipe for botching future predictions:

From the end of 2002 to the early months of 2007, prosperity seemed firmly rooted and even touched by some kind of magic. The Fed appeared to have inflation under control, productivity was high, no squalls were hitting the stock market, the dollar’s decline was orderly, home prices generally rose steadily, and the unemployment rate fell in many months. Even better, investors could buy all those interesting new forms of financial paper invented by the engineers, offering high yields at what the rating agencies assured investors was low risk.

But the magic was not in concrete; it never is. The conviction that risks were low led investors to take greater risk without requiring higher expected returns. By late 2006, the Fed was wrestling with inflationary pressures from oil and food, productivity had lost its momentum, housing prices had been declining since summer, and the mortgage markets were starting to crack.

Nevertheless, like me in 1958, investors refused to see the ground shifting beneath them, even though the environment was no longer what they knew and thought they understood. Like me, they were walking into a trap where the responses were not what they had anticipated. Like me, they were headed toward big surprises for which they had no preparation.