Economic forecasts, fortune telling and sunspots

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An enticing looking book has arrived in the post. It’s [amazon_link id=”0691159114″ target=”_blank” ]Fortune Tellers: The story of America’s first economic forecasters[/amazon_link], by Walter Friedman.

[amazon_image id=”0691159114″ link=”true” target=”_blank” size=”medium” ]Fortune Tellers: The Story of America’s First Economic Forecasters[/amazon_image]

It’s easy to make fun of economic forecasts, which are always wrong. Nate Silver’s [amazon_link id=”0141975652″ target=”_blank” ]The Signal and the Noise[/amazon_link] has a chapter explaining with care why this is so, without bothering to score the cheap shots many critics resort to. Essentially, he points out that the macroeconomy is a large complex system with many feedbacks, about which we have very little data. Economic forecasting lags well behind weather forecasting in its gathering and use of statistics. David Hendry and Mike Clements have written, for my money, the best book on how to do time series forecasting given our current data and knowledge, [amazon_link id=”0521634806″ target=”_blank” ]Forecasting Economic Time Series[/amazon_link].

There has been progress. W Stanley Jevons famously correlated economic activity with sunspots. The theoretical basis for this might in fact have grown stronger now there is so much electronic communication for solar storms to disrupt. Fans of Kondratiev cycle-type analysis sometimes stretch the insight that applying disruptive technology can require generational change to trying to forecast the cycles.

I’m sympathetic to macro forecasters as I used to be one myself for a couple of years. It was an eyeopener to me, a relatively freshly minted, idealistic PhD, to realise how much fiddling there is to make any forecast look even plausible – they all require it –  and therefore how strong the herding instinct among forecasters. It took me another giant stride on my journey from macro to micro. I was working for Data Resources Inc, founded by the eminent US macroeconomist Otto Eckstein in 1969 (now part of Global insight).

[amazon_link id=”0691159114″ target=”_blank” ]Fortune Tellers[/amazon_link] stops before the Second World War, however – that is, before modern macro models. It looks great fun.

Life and art

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Sometimes, cliches are true. Life does imitate art.

Google is launching a healthcare company, Calico, to investigate ageing and longevity. Larry Page said the project is about, “Longer term, moonshot thinking around healthcare and biotechnology.”

The search (algorithmically) for eternal youth is exactly what Robin Sloan’s fun novel [amazon_link id=”1782392335″ target=”_blank” ]Mr Penumbra’s 24 Hour Bookstore[/amazon_link] identified as the new Google obsession.

[amazon_image id=”1782392335″ link=”true” target=”_blank” size=”medium” ]Mr Penumbra’s 24-hour Bookstore[/amazon_image]

A room full of naked bankers

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This morning I had the pleasure of attending a breakfast debate hosted by Prospect for Anat Admati, co-author of the [amazon_link id=”0691156840″ target=”_blank” ]brilliant The Bankers’ New Clothes.[/amazon_link] The book has a clear, simple message: banks should be required to  behave like normal businesses, and invest their own funds in projects with a good (risk-adjusted) return. They should not be subsidised to borrow money to invest in risky trading activities. “What is special about banks is what they get away with,” Admati says. The mechanism for moving from our world of zombie banks that can still bring down the whole economy and are still receiving massive taxpayer subsidies to a world of viable banks that finance the real economy is to require them to hold much, much more equity on the liabilities side of their balance sheet, moving towards that by not paying dividends for the foreseeable future.

[amazon_image id=”B00BBYLPYY” link=”true” target=”_blank” size=”medium” ]The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It[/amazon_image]

The book is terrific, and if you don’t want to read a  whole book, its website has a short myth-buster addressing the most frequent objections to the proposals ( http://bankersnewclothes.com/wp-content/uploads/2013/06/parade-continues-June-3.pdf). For of course bankers object to being told their industry harms the economy and is not commercially viable without government subsidy. Many people – including both politicians and many bankers – don’t understand the issues. There’s a lot of jargon and few people want to look stupid by admitting they don’t understand.

The meeting this morning split between bankers and economists. I think all economists agree on the need for banks to be much better-capitalised. This includes a senior economist at one of the UK’s biggest banks, who recently told me so then pleaded with me never to reveal their identity. However, this has little political traction. Bankers are confident chaps who talk a good (confusing) game and donate funds. The GDP figures greatly overstate the contribution of banks to the economy (see my forthcoming book, or [amazon_link id=”1444338293″ target=”_blank” ]Banking Across Boundaries[/amazon_link]  by Brett Christophers). I think the best practical path in the short term is to encourage regulators and politicians to enable new entry into financial services. After all, only 3% of banks’ lending in the UK goes to business, and if start-ups including P2P and private equity can eat into that, it will be even clearer that the banks we have are not socially useful. If they are, they can prove it by raising equity and reducing their lethally dangerous leverage.

Beyond GDP

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[amazon_link id=”019976719X” target=”_blank” ]Beyond GDP: Measuring Welfare and Assessing Sustainability[/amazon_link] by Marc Fleurbaey and Didier Blanchet is a technical book on the profoundly important question of how we measure “the economy”. The authors are two distinguished economists/statisticians who were respectively a member and rapporteur for the Sen-Stiglitz commission appointed by the then French President to consider whether there is a better kind of metric than GDP. This is of course a subject about which there has been considerable debate over the years. Although this is a technical book, the algebra should not defeat a professional economist, and the explanations are very clear. The introduction is well worth a read by anybody interested in this debate.

[amazon_image id=”019976719X” link=”true” target=”_blank” size=”medium” ]Beyond GDP: Measuring Welfare and Assessing Sustainability[/amazon_image]

The book’s concludes that we should be talking about “GDP and Beyond”, because GDP is adequate for measuring production and income. However, when it comes to the ‘beyond’, the authors convincingly show that a number of commonly-proposed alternatives have significant flaws in theoretical terms.The alternatives take one of two forms: a composite index that adjusts GDP in some way, either by subtracting some elements or weighting it with other kinds of indicator; or measuring well-being directly via surveys.

On the composite indices, the book points out that they are arbitrary and lack analytical foundations. They make implicit assumptions about substitution possibilities between their components. They aggregate together inputs, intermediate products and outcomes. There is almost no informational gain from these ‘corrected’ GDP alternatives. They are, to sum up, a dog’s breakfast.

The authors are no more impressed by measures of well-being or happiness. They disagree that happiness is the right or ultimate goal. “Taking happiness as the ultimate goal in life is far from normal and popular.” Indeed, normal views of morality tend to regard hedonism as a negative, not a positive. As for the ‘Easterlin paradox’, they note that subjective well-being indicators fail to account for the way people calibrate their expectations depending on what they are used to; it is simply implausible to think people do not have a strong preference for, say, the greater longevity normal now compared to 50 or 100 years ago, but they answer surveys in ways calibrated to their experience of how things are now. Not only is GDP not bounded, while surveys are answered on a 1-10 scale, but “People are induced to reason in relative terms when they must describe an open-ended object, their lives, on a closed scale.”

As the book points out, measuring current welfare is one thing, but measuring sustainability is another – and much harder. It is a separate challenge, although they are often merged. The reason for the intrinsic difficulty is that it isn’t possible to compare present consumption or activity to as ‘sustainable’ level without taking a view about the future – and not just one specific future but the entire possibility set taking account of uncertainties about how the world is now and how it may change as people’s behaviour and preferences change. “It is illusory to believe that all the information we need about the future is already present in current observations.”

This all sounds rather negative. If the conventionally-proposed alternatives are so flawed, and sustainability is intrinsically hard, is there any better alternative?

The book goes part way to an answer. It recommends looking at a version of ‘adjusted net savings’ to measure sustainability. This involves looking at changes in the stocks of relevant assets, whether physical, human or natural capital. The authors recommend a carefully-structured dashboard of indicators of over-consumption or dissaving, with the ‘Goldilocks’ aim of being neither too aggregated to be meaningful nor too disaggregated to be easily understood. On current social welfare, they recommend the ‘equivalent income’ of non-market activities or outputs, that is the income that would give the same utility as non-market dimensions of welfare such as health, the environment or social connection. This is a well-known bit of the economics toolkit, asking people how much they would need to give up something. This is better, the book argues, than making the a priori assumptions involved in present composite indicators. And it gives a clear metric for assessment, namely money: “Whatever one does, aggregation implies putting relative values on very different items, and doing so in monetary units is no less respectable than the apparently dimensionless valuations implicit in composite indexes.”

I think this carefully-argued book is very persuasive – this is not an easy challenge, and the analytical issues are set out here with great clarity. It did not give me a clear idea of how the preferred methods would be put into practice, but no doubt statisticians are working on this. The effort is certainly worthwhile, and after all, calculating GDP is itself a complex and time-consuming business. The one point on which I’d disagree with them is the throwaway line that GDP itself is ok and should be left alone. I certainly think we need GDP but it will itself need reconsidering as it might not be the best way to measure an increasingly intangible, service-based, economy with a huge proliferation of variety and complexity. More on that in my new book GDP: A brief and affectionate history, out early next year!

Banker bashing*

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This week I’m getting to attend an event at which Anat Admati is speaking, which is exciting. Her book with Martin Hellwig, [amazon_link id=”0691156840″ target=”_blank” ]The Bankers’ New Clothes: What’s Wrong with Banking and What to do About it[/amazon_link] is terrific – it’s on the shortlist for The Enlightened Economist prize, and I reviewed it here. The main message is simple: banks need to hold more capital, less debt, on their balance sheet, because it’s too risk to have massive financial institutions made insolvent by a 4% decline (say) in the value of their assets. We’d consider the kind of debt/equity ratio that characterises the banks as ludicrously over-leveraged in any other business, so why is it considered ok for banks to have so little capital? The book thoroughly debunks the claim that higher capital requirements would squeeze lending to businesses: the proportions of debt and equity on the liabilities side of the banks’ balance sheets have no automatic implications for the amount lent on the assets side. (Banks’ cost of funds would increase somewhat.)

[amazon_image id=”0691156840″ link=”true” target=”_blank” size=”medium” ]The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It[/amazon_image]

I’ll report back on the event. Meanwhile, there is a new book on RBS, Iain Martin’s [amazon_link id=”147111354X” target=”_blank” ]Making It Happen: Fred Goodwin, RBS and the Men Who Blew Up the British Economy[/amazon_link]. Ian Fraser’s [amazon_link id=”1780271387″ target=”_blank” ]Shredded: The Rise and Fall of the Royal Bank of Scotland[/amazon_link] is due out early next year.

[amazon_image id=”147111354X” link=”true” target=”_blank” size=”medium” ]Making it Happen: Fred Goodwin, RBS and the Men Who Blew Up the British Economy[/amazon_image]

[amazon_image id=”1780271387″ link=”true” target=”_blank” size=”medium” ]Shredded: The Rise and Fall of the Royal Bank of Scotland[/amazon_image]

Quick update: Admati has a letter in today’s Financial Timesknocking down the undead myth that ultra-high leverage has some benefits: “If banking shrinks because some banks are not viable at a level of 30 per cent equity, the economy stands to benefit. … Lending suffers when banks are weak, and bankers use subsidised funding to boost their ROE in derivative and other markets.”

* They still deserve it for fighting tooth and nail every post-crisis attempt to prevent the same kind of thing happening again.