My impression has long been that macroeconomic forecasts are nearly useless. As a check, I pulled a decade’s economic forecasts from the White House’s Council of Economic Advisers.
The Council is staffed by top-flight — often Nobel-quality — economists, and while their forecasts can have a political tinge, they rarely stray far from the professional consensus. I started with the 1997 report, released early in the year, when the dot-com boom was well underway.
The Council thought the economy’s maximum sustainable real growth rate was 2.5 per cent, and expected 1997 growth of only 2 per cent. The actual outcome, however, was a stunning 4.5 per cent. In their next report, in early 1998, the Council duly registered their astonishment at such a splendid 1997, but stuck with the expectation of slow growth, predicting a reversion to 2 per cent for the new year. But the 1998 outcome, yet again, was more than twice as high as their forecast. They cautiously raised their forecast for 1999, but still seriously erred on the downside. By 2000, finally, they acknowledged a fundamental shift in national productivity, and sharply raised both their near- and medium-term outlooks — just in time for the dotcom bust and the 2001-2002 recession.
The Council’s record during the Bush years was no better. They seriously over-forecasted growth in 2002 and 2003, and once the economy was in full recovery mode in 2004, confidently expected that high growth had settled in for the long term. The 2008 report expected slower but positive growth in the first half of the year, as investment shifted away from housing, but foresaw a nice recovery in the second half, and a decent year overall. Their outlook for 2009 and 2010 was for solid 3 per cent real growth with low inflation and good employment numbers.
In other words, they hadn’t a clue. Nor did chairman of the US Federal Reserve Ben Bernanke, a fine economist, in February 2007, when he described to a congressional panel what the New York Times called a "Goldilocks" economy — neither too hot nor too cold. The weakness in housing, he told them, had stabilised and would not spill over into the rest of the economy. And Bernanke sits at the intersection of as big a collection of economic and financial data as there is to be found anywhere in the world.
So why could Buffett, Soros, and Volcker all see the crisis coming from far down the road, when the professional forecasters so consistently got it wrong? And the answer, I think, is wrapped up with the state of economics itself.
Understanding what’s wrong with economics wouldn’t be so important if we treated economists like weathermen or stock gurus. If a weatherman says it’s going to rain today, you bring an umbrella, but most of us ignore forecasts that look more than a few days ahead. We watch the antics of a TV personality like Jim Cramer talking about finance for the entertainment value, but few serious investors tune in for real advice.
But the economics profession is taken very seriously. Companies build their spending and investment plans around their economists’ forecasts, and the government looks to the profession for guidance on an ever-broadening range of public policy questions. Economists will play a major role in setting the Obama Administration’s healthcare agenda, and they are establishing the terms of debate for the economic stimulus program and the financial bailouts.
It’s worth reflecting briefly on how much has gone wrong and how fast it happened. The unique feature of the current crisis is that it is a balance-sheet crisis, a credit overshoot, originating within the financial sector. That’s one of the reasons it’s so nasty. Credit is the air that markets breathe. Toxic credit infects all asset classes, and the American market presence is so big that the infection has spread throughout the world. And the economics profession failed to see it coming, even as the economy grew wildly out of balance.
There was much evidence of things gone awry. Corporate profits grew very strongly in the 2000s. From 1960 through 2007, after-tax corporate profits averaged 6.5 per cent of national income. In the four years from 2004 to 2007, the average was 10.8 per cent, shooting up to 11.8 per cent in 2006 and 2007. But even as profits grew strongly, the rate of corporate investment fell, so free corporate cash flows grew mightily. Conveniently, Congress changed the tax code to encourage cash distribution to shareholders.
The companies that make up the S&P 500, from the fourth quarter of 2004 to year end 2007, made US$2.1 trillion in net earnings. They gave all of it back to shareholders in the form of dividends or stock buybacks. Shareholder distributions were about a third larger than capital investment.
Those huge streams of free cash went mostly to institutions and wealthy investors, and were invested primarily in financial instruments. The powerful surge of money into stock and bond markets raised asset prices and drove a steep drop in yields. Falling yields encourage risky behavior like the huge buildup of leveraged trading assets at the biggest banks, and the preference for the higher yields available in consumer debt. The Federal Reserve did nothing to stop the asset boom; indeed, by keeping interest rates inordinately low for an extended period, it greatly encouraged it. The financial sector quickly became the primary driver of the economy, accounting for 40 percent of all corporate profits by 2007.
Disquietingly, something similar happened in the 1920s. Corporate cash flows grew much faster than investment or wages and the excess flowed into financial instruments. There was a burst of inventive consumer lending, both through residential mortgages
and installment purchase debt, including some of the same instruments, like interest-only mortgages, that got banks like Countrywide in such trouble. And when banks got worried about their shaky loans, they bundled them up — or "securitised" them — into highly leveraged "investment trusts" that they floated on the stock market. It all has a familiar ring.
In our own day, the flood of finance pushed consumer spending to 72 per cent of GDP, the highest rate ever, anywhere, while personal savings rates dropped to virtually zero. Very quickly, Americans became grossly over-invested in items that Wall Street was good at financing — bigger houses, SUVs, electronic toys from Asia. Secondary booms duly followed — in new shopping malls; in the shiny new office buildings and the luxury hotels and restaurants that bankers like; and in highly leveraged buyouts of companies riding the same waves, such as hotel chains, retailers, casinos, furniture stores, and home builders.
And when there were no good assets to lend against and a dearth of creditworthy borrowers, the financial sector just kept on lending, inventing "ninja" mortgages ("no income, no job or assets"), "no-covenant" company takeover loans (if you can’t pay, the lender can’t make you), and other corruptions. In the 2000s, Americans spent 105 per cent of what they produced, with most of the overrun on the household accounts.
In other words, the economy was completely out of whack. Why couldn’t economists see it? Well they did, of course, but since their models assumed that markets are always right, they constructed new theories to explain why markets were behaving the way they were.
A favorite was the "Global Savings Glut", announced with some fanfare by none other than Ben Bernanke in 2005. The idea was that the soaring American international debt and trade deficits were caused by "excess global savings", especially in emerging markets like China. It’s not true. At best, global savings were flat in the 2000s. Their locus shifted, as the United States ran down its savings to buy consumer goods and oil. It was the American credit binge that was the channel for building emerging market surpluses, lubricated by the near-total deregulation of mortgage and credit card borrowing.
(From 2000 through to 2007, Americans withdrew $4.2 trillion in mortgage equity from their homes; it was equivalent to 6.1 per cent of gross disposable personal income over that period. During that same time, the American goods and services rade deficit was $4.5 trillion. Not a coincidence.)
Without the benefit of modern statistics, and with nary a macroeconomic model to lean on, a Nicholas Biddle, a Walter Bagehot, or any other avatar of 19th century central banking would have known what to do when their economy foamed up the way ours did. Tuck up interest rates, slow things down, don’t let the trade balance get so far into the hole, rein in government borrowing. It’s just common sense.
But America’s regulators took no such action. Certainly, putting the brakes on the growing asset bubble would have slowed growth and quite likely caused a recession — but Greenspan had been deified for avoiding recessions. And Wall Street would have screamed bloody murder. So they let it rip. And once the cycle locked in, it became self-amplifying as countries like China developed a huge stake in keeping it going.
But the fundamental causality ran from America to the world, not the other way round. Theories like the "Global Savings Glut" were a species of panglossian rationalisation, reckoning that everything was being driven by larger market forces, beyond the control of regulators. Not to worry — they reassured each other — it was all part of the benign process by which efficient markets work a smooth rebalancing. In reality the theories were just craven self-exoneration — academic cover for why the authorities stood aside and let Wall Street blow up the world.
This is an edited extract from Charles R Morris’s book The Sages: Warren Buffett, George Soros, Paul Volcker & the Maelstrom of Markets published by Black Inc.
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