U’s And V’s

(Fooling around with the credibility of global forecasts. Or the lack of it therein.)

The collapse of ability to forecast during this current global economic crisis, resulted in the abandonment of the previously employed semi-sophisticated merge of national level macro models, and the return of the U’s and the V’s. The debate is reduced to discussions whether the recession will take a u-shape or a v-shape. Not being able to do anything with the data, one can always ignore it, and assume that whatever is happening is merely a blip in the trend. All you have to do then is to figure out how fast your subject, the global economy, will return to its well established long term behaviour.

And thus the two new ‘theories’ of this crisis were born: u-shaped versus v-shaped. In both cases, the previously ‘detected’ trend will return, the only question is how long we will have to wait for it. ‘Phase transition’ is not exactly in the vocabulary of economics…

On the history of U’s and V’s.

Incidentally, I witnessed a previous occasion for these two letters to rule the explanations-and-forecasts-find-it-here business. The history of economic thought during the post-communist transition will surely spend many words on how the lack of any adequate model of what transition was, of how an economy behaves during those times, and what comes after, had resulted in the rise of discussing curve shapes. Even in some textbooks taught today, well after the rise of the New Theory of Transition, intellectual laziness keeps winning, and the discussion of the u-shaped dynamics persists.

Yet, in reality, the reduction to observing the shape of the curve, an arbitrary pattern projected onto a time series, very much in line with the statistically irrelevant, but much watched ‘technical analysis’ of capital market price data, was merely the result of no models working at all. In the early years of post-communist transition, there were three sets of theories that were offered as ‘the truth’. A bunch of economic-liberal economists, mostly of Anglo-Saxon origin, pushed ahead with the microeconomic theory of privatisation. They should have given up after a quick check, for it is obvious that the privatisation of an entire economy has nothing to do with the lessons learned from the nationalisation-privatisation saga of the British Rail. Nor, did the Theory of Poor People (a.k.a. development economics), for although the poverty stats showed a fairly bad picture, the reality had more to do with very high human capital levels all across the transition world, which rendered much of the prescriptions entirely irrelevant. Nor did the balance-obsessed monetarist approach, for - at the beginning at least - there were no institutions around that could deliver the ‘adequate policy mix’, while the underlying structure was going through a rapid and radical change.

Thrilling it is, how similar the the global economy theory-pretence is to the transition theory-pretence. The intellectual abyss is paired with a yes-of-course-I-know-EXACTLY-what’s-happening shamelessness.

On the consequences on ‘What the hell is happening to me?!?”

The previous post discussed how the IMF’s Word Of Final Truth, as usually taken without the warning about the side effects, has nothing to do with reality. Even if they happen to be right in retrospect, that will be a random event (and an unlikely one, in my view). However, there is one more phenomenon, which is mostly disregarded: the Other Views about where the current troubles come from.

One of the favourite economist bashing topics of our days is how unforeseen the current crisis was. And then a few puts their hands up and say, well, actually, they themselves had foreseen these events, and then follow on with digging up some old forecast of theirs as an evidence. That exercise is semi-interesting at best, though. For forecasting is a multi-dimensional effort in a random world, and thus if a high enough number of people are involved, there will always be some in the tail, to point at their amazing-foresight once the low probability event they forecast takes place.

A lightning will hit this bush! A lightning will hit this bush!! A lightning will hit this bush!!! Watch out!!!! Bang. Thump. Fire. OMG, OMG, I am a prophet! ... Okay, people, here is what you need to do from now on.

(Btw., my mother thinks she has healing power in her hand, so I have been well versed in the beauties of self-delusional explanations well before my first macro class… What the funniest is that she is also exceptionally gullible to the same tricks coming from other charlatans. See also the economics equivalent: the consensus long-term forecast...)

There is perhaps another interesting feature here. That is the other tail-forecasters who foresaw the end of the world, but via a different mechanism than the sub-prime and co. story. I was one of these lunatic visionaries, arguing that the sky is about to fall from some six years ago onwards. But my own eschatological visions were more to do with emerging market macro than with US mortgages. There were also the people who were worried about too high complexity of new instruments, those who worried about excessive risk taking in general (a.k.a., bonus structure induced gambling), and those who kept fretting on about global imbalances, particularly the current account deficit of the US. What is interesting maybe is the common element in the thoughts of all of all of us crazies.

The intersection it seems is complaints about the markets misjudging a particular risk element, and thus ending up with ‘wrong’ valuations. In my universe, it was the lack of separation of different emerging markets. For it seemed very clear that the risk associated with different developing countries by the financial markets had little to do with the real underlying fundamentals. All our forecasts were based on national level behaviour being projected onto a global economic trend, the latter being entirely exogenous variable, in just an aggregate in essence. If the global forecast is solid growth, then portfolio flow dynamics will rule the day. That’s it.

My suspicion is that it was the same lack of real global modelling that lay at the base of all of our fringe end-of-the-world-is-here predictions. In some cases directly (emerging markets, global imbalances), or indirectly (mostly due to lack of adequate policy response to misalignments, valuation or structural, or the misjudgement of the impact of deregulation).

In the post-communist transition case, the u-shape focused intellectual abyss was followed by a set essentially random policy action (a true lab-experiment, given the high number of countries involved in it at the same time) coupled with an independent theory-event (the rise of the endogenous growth models) that gave rise to an understanding about what was really going on. If we insist on being optimists, we might say that the current U’s versus V’s nonsense may give rise to real thinking. For that, of course, you need one of these random policies work first...