Roots of Crisis: Why Economic Forecasts Failed?

Yesterday, Feb 27, it was announced that in the last quarter the U.S. economy shrank at a 6.2 percent annual pace. According to the median estimate of 74 economists surveyed by Bloomberg, GDP was projected to contract at a 5.4 percent annual pace; forecasts ranged from 3.8% to 6%. Moreover, the 2.4% deviation from the previous forecast was almost five times as large as the average adjustment.

Couple more examples...
- Early in 2008, the Bank of Canada forecast the Canada’s economy would grow by 2.8% in 2009 and predicted $200-a-barrel oil. Impact of subprime mortgages was widely expected to be quite temporary.
- Canada lost 129,000 jobs in January 2009; way more than the consensus of economists which called for only 40,000 losses.

How did economists miss their targets by a mile?
Well, they admit that they are not that good at forecasting “turning points” like recessions. They missed this recession; moreover, the early 80s and early 90s recessions were not very well predicted either.
However, it looks like they are not very good at forecasting on quarter scales either. So, what is the problem? And why did they miss the change in consumer spending/saving ratio? There are a couple of reasonable explanations:

Herding behavior
Herding behavior is one of the reasons:

"There’s a considerable reward for being the outlier and being right, but I think
there’s a severe punishment if you’re an outlier and you’re wrong because then
you really look bad. It’s not like everybody missed it. You alone missed it."– Don Drummond, Chief Economist at TD Bank.

Focus on Growth
Such as our economic reporting is focused primarily on growth the most of attention is typically being paid to GDP and socially important indicators: inflation and unemployment. Other important variables (consumer spending, government spending, export, and import) are being monitored, but usually they are a part of more professional discussions.

Mainstream Economic Models
Nevertheless, the major problem of economic forecasting is that mainstream economic models are extremely complex. I analyzed problems associated with this complexity in an article about mainstream economic forecasting. The two major consequences of this complexity are:
- mainstream economic models do not have predictive power for turning points and they are inadequate for unusual economic situations (like current)
- with the huge number of parameters and variables it is hard to see the whole picture.

So, what is the point of a weather forecast which by definition can’t predict a hurricane, tornado or major snowstorm? Probably nobody would pay a buck for such service. Fortunately, we have weather forecast services which are able to predict major weather patterns. Also, we managed to build a tsunami forecast service, which will probably save thousands of lives in the future. There is a downside of their imperfect forecasts – sometimes they issue false positive (no issue, but forecast identified one) warnings. But, it is perfectly fine. It is much better than false negative (there is an issue, but forecast did not identify one) warnings which were constantly issued by our lead economists. False positives save lives, false negatives lead to casualties, bankruptcies and foreclosures.

Roots of Crisis

Such as we still don’t have a comprehensive answer (other than Wall Street greed and predatory lending practices) what went wrong and why we are in the recession I decided to dive deep into the topic. The following several articles are the result of my extensive research and data mining.

My major conclusion is: mainstream economists and U.S. policymakers overlooked the substantial change in the consumer spending/saving pattern and failed to act properly. This change in regime started approximately in 1993 and is accounted for both dot-com bubble and the current depression (note, it is not a recession).

The results of this overlooking will be extremely severe: more than 10% drop in GDP and significant (up to 15%) unemployment. Economy will not rebound from this nose-dive. If we do not reinvent ourselves, after this depression the economy will grow not faster than by 2 percent annually.

The stimulus package is vitally necessary. It will not prevent economy from plunging to the new, lower level, but it may smooth transitioning from the current state to the new one (e.g. it will not allow the economy to plummet by 20% and than recover by 10%) .

All these figures are for the U.S. economy. Health of the Canadian economy is much more dimmed and will be mostly determined by the transitioning of U.S.economy. The only one thing is obvious - there will not be any recovery in the second half of 2009 as promised by Mr.Carney.

In the next articles I discuss why economic forecasting is important, what was particularly overlooked and why it was ignored. Finally, we will discuss the grueling consequences of this negligence.

Are we climate-change deniers?

Momoko Price in his latest article in the Toronto Star analyzes why most of us aren't doing much about climate change. Lack of actions is caused by many reasons: people are programmed to want results right away; humans tend to want to respond by doing just one thing (e.g. changing bulbs), but, there is a silver lining: our susceptibility to peer pressure. By applying social norm we could not just change attitude but also solicit required actions.

It definitely makes sense. But, establishing social norms requires government actions. And governments even do something in this direction - e.g. on Jan. 24, U.S. President Barack Obama called for the installation of 40 million smart meters in American homes; the Ontario government has already promised to install smart meters in every house and small business by 2010.

However, here we have a classical double-standard problem. From one side, the government establishes a smart metering social norm and targets ambitious 2% reduction in energy consumption. From the other, it subsidizes oil&gas industry.

With such mixed messages I doubt that any kind of public campaigns will be able to cause any significant changes in our behavior.

To change our behavior clear and coherent messages from the government confirmed by appropriate financial incentives are required (e.g. revenue-neutral carbon tax).

Ontario in the Creative Age

Fortunately, my first impression of the "Ontario in the Creative Age" report was oversimplified. My second thought: bold and visionary study. Not all proposals are actionable, but it is a good starting point in goal-setting. Some comments:

Talents: While we have only 22.3% of population over 25 with university degree in general, this concentration is much higher in Greater Toronto, Ottawa, and Kitchener-Waterloo regions. We can take advantage immediately, strengthen existing clustered industries and seed new ones.

Technology: A number of patents per capita is not a reliable indicator of level of technology (though it is pity that we are behind almost all OECD countries). Japan in 50-60th mostly procured patents, however was able to build an innovative economy. It is a matter of management and culture.

Clustering: We have to take full advantage of our existing human capital and seed new industries: bioscience, alternative energy. This step will set demand on researchers and immediately: a) re-employ some professionals with university degree who are underemployed on routine-based jobs, b) increase attractiveness of creative jobs and stimulate college enrolement.

This crisis is a unique opportunity to build a new economy and prosper. But we must act and act quickly!

P.S. Fasttrack roadmap for Toronto: due to the presence of world-class research facilities (University Health Network, The Ontario Cancer Institute, etc.) Toronto can be positioned not just as a center for financial-related jobs (which can be easily outsourced), but also as a bioscience center (these jobs require significant infrastructure spending and cannot be outsourced easily.) To make it happened all we need to do is to give biomedical companies a 5-10 year tax holiday (subject to some conditions). Perhaps the budget will not receive some corporate taxes (which are anyway highly doubtful for companies with long R&D cycle) but we will have a significant increase in personal income taxes from highly paid researchers, bust in lodging, etc.

Creative Edge for Ontario

The day after I published my Sustainable Ontario post, Richard Florida and Roger Martin announced their report "Ontario in the Creative Age". While definitely being a step in the right direction, the report is not overly-ambitious and actionable. Some excerpts:

"Currently, in Ontario, 30 percent of our jobs are creativity-oriented, and they account for nearly half (47 percent) of all our wages. ...To realize a competitive advantage for Ontario and ensure broad prosperity for all Ontarians, the province should strive to have more than 50 percent of its employment in creativity-oriented jobs by 2030."

It can be easily done much faster (5-7 years instead of 21) in major areas: Greater Toronto, Greater Ottawa and Kitchener-Waterloo using existing human capital provided that provincial and federal governments a) grant appropriate incentives to the biomedical and telecommunication companies and b) create new scientific centers and facilities. These measures employ temporarily a lot of currently laid-off workers on construction and create a lot of knowledge-based jobs in the long run.

"To meet the need that 70 percent of new jobs require post secondary eduction, we must aim to have a 60 percent participation rate among our 18 to 24 year olds. ... About 40 percent of our 18 to 24 year olds are currently in post secondary education. We expect this will reach 50 percent in the next twenty years based on the current momentum."

Our 18 to 24 year olds (as well as all other human beings) are very responsive to incentives. If a researcher in the University of Toronto with PhD earns $45,000 a year and struggles to resume a contract every single year, it is very appealing to find a routine-based job in unionized environment starting from $50,000 and do not waste any time (and money) in colleges and universities. The message is clear- we need to change this perception first. And it cannot be done without government intervention.

The bottom line is... It is only the government that can change the HR landscape in Ontario. By shifting its support and subsidies from companies with routine-oriented jobs to creative-oriented ones (it actually can be the same company, e.g. GM) and creating additional workplaces in publicly-funded research and education the government will send a strong message to business community and population, which are very susceptible to incentives. And it is the only way to our prosperity.

Sustainable Ontario

"There's no place like this"
The slogan of Ontario

And it is true. For more than two decades Ontario and especially GTA was a unique crossroad, which absorbed (and still absorbing!) the significant part of new immigrants. Canadian immigration policy welcomes primarily independent immigrants (which typically are high-skilled professionals), that is why during last twenty years we managed to build the strong community with very high level of education (e.g. GTA is the 3rd biggest IT center of North America with 300,000 IT professionals).

But, our economic policy is still characterized by short-sighted subsidizing - rather than transforming- declining sectors like the auto industry. Why should a foreign PhD work on an autopart plant or drive a cab? Is it more productive?

With all its human capital Ontario should be a center of science and 21st-century industries, not an assembly plant. Ontario requires not physical infrastructure upgrades but long-term public investments in scientific research and development. This is a unique opportunity to switch to 21st-century industry and pull out of this crisis with a greener and more competitive economy.

Some thoughts about green energy

We all know fossil (and especially coal) power is dirty power, but all non-fossil power projects like nuclear power or incinerators and even renewable power projects like wind farms routinely face fierce opposition.
As older power plants age, they need to be replaced. However, we will have a hard time letting go of fossils until we change our attitude, which cannot be done without proper incentives from the government. Leadership and vision are required...