Judge economists' forecasts on method, not decimal points
At the end of each year, economists are judged by colleagues, the press, and the business community to see who came closest, within a few decimal points, in predicting the nation's output, inflation, interest rates, etc. Is that the very best way to judge the value and the success of an economic forecast?
The economists may just be right for the wrong reasons. But no one will know that, because penetrating questions about methodology are seldom asked.
It's curious, for instance, that economists often speak reverently about the Federal Reserve but don't include any reference or assumptions about monetary policy in their economic forecast. Nor do they explain how this policy influences the economy.
Economists often act as though the Fed has the ability to determine the level of interest rates over six or 12 months -- but these same economists often ignore the money supply.
Anyone reading the minutes of the Federal Open Market Committee would be left asking the question, ``Why are Fed officials so concerned about the rate of growth of money? It must be important, and if it is, why do so many economists ignore it?''
Then there's fiscal policy -- taxing and spending by government. Everybody can relate to that. Just about everybody is taxed, and just about everybody is the recipient, directly or indirectly, of government spending.
Keynesianism holds that increases in government spending benefit the economy. But today, even fiscal policy receives little treatment in forecasts. The deficit, of course, is too big, even though deficit financing is deemed to be stimulative.
Instead, forecasts often rely on trends that seem fashionable under current circumstances. The most fashionable element in today's forecasts is interest rates. There are those who believe that with inflation running at less than 3 percent, interest rates are too high. This group, therefore, holds that the economy will grow at a very sluggish rate in 1986.
Of course, we enjoyed a very high growth rate -- more than 6 percent in real terms -- in the first year and a half of the recovery in spite of interest rates that were higher in both nominal and ``real'' terms. You may remember there were many forecasters who said that because interest rates were too high, the recovery would be short lived.
A great many of the forecasts for 1986 simply represent an extrapolation -- 1985 all over again. Others say the recovery is getting feeble, because it is getting old. Recoveries from recession have averaged 42 months. The one we are now in is 37 months old. Such forecasts implicitly ignore policy, as though it doesn't exist.
In my experience, consistently good economic forecasts rely on using theory to determine the effects of policy. As far as policy is concerned, monetary and fiscal policy has been highly stimulative. Officials in Washington want stronger growth than that which occurred in 1985. And we are likely to get what they want.
Good economic forecasts should not be measured by precise numbers. For example, a forecast of slow to moderate growth would embrace, say, a 2 to 3.5 percent increase in real GNP for the year.
A forecast for a relatively strong increase would be one that called for between 4 and 5.5 percent. Obviously anything over 5.5 percent would be very strong, and anything below 2 percent would be very slow. But those who employ the correct verbal description of what they expect can still claim success if the numbers fit that description. In other words, in qualitative terms, one group can be said to be forecasting a sluggish-to-moderate growth rate, while the other expects a relatively strong economy, significantly better than in 85.
I don't know many businessmen or financial portfolio managers who make business decisions based on GNP forecasts. They think in terms of a weak economy or a strong economy. Rising interest rates or falling interest rates. A rising stock market or a falling stock market. An inflation rate that rises, falls, or remains unchanged. A dollar that weakens in the exchange markets, or grows stronger. They are not interested in the last decimal point.
The ability to reason correctly in economics, employing demonstrated theory correctly, makes a difference. Good forecasts are those that enable the user to make decisions consistently which either limit losses or enhance gains.
The fact that many economists don't reveal more of their methodologies, or talk more about policy and theory in their forecasts, reflects badly on the economic forecasting profession. Methodology, and not the last decimal point, should receive the accolades.
In the natural and physical sciences, as well as many of the social sciences, people are recognized for their achievements because they have contributed significantly to the body of knowledge in their particular field. Indeed, in the natural and physical sciences, a particular theory is accepted by the profession because it can be replicated by others.
Just think where we would be if only Thomas Edison could make and run generators, or if only the Wright brothers were able to fly an airplane. Yet there are so-called gurus who maintain that only they possess the skill needed in economic forecasting. And the public and the press heap praise upon these individuals as they rotate on occasion through the winner's circle. Yet no one appears consistently when winning is based purely on the numbers.
It is rather curious that in economics, which is a social science, where absolute precision is impossible, people are inclined to place so much importance on accurate numerical forecasts and give awards to what are essentially guesses, largely ignoring the methodology or the contribution to theory. In the physical sciences, where precision is often possible, people are rewarded for the substance of their theories, for their reasonings, for their contributions to the literature which can be used by anyone. The irony of this is overwhelming.
Leif H. Olsen, former chairman of economic policy of Citibank, is now economic consultant to Citibank and a private economic adviser.