06 January 2013

WSJ: A dire showing from a dismal bunch

The European Commission and the International Monetary Fund expect the region's economy to grow by 0.1 per cent and 0.2 per cent respectively, while Capital Economics expects it to shrink by 2 per cent.

Forecasting is by its nature a hit-and-miss affair; economics is not—despite the apparent dogmatic certainty of some of its practitioners—an exact science. But the track record of the profession in recent years—and last year in particular —is dire. Few economists spotted the boom and most hopelessly underestimated the bust. And it's not as if the profession's troubles in 2012 were limited to longer-range forecasts; it was getting it wrong virtually in real time with most forecasters forced to slash their projections every few months as each quarter turned out worse than expected.

The scale of this analytical failure is increasingly worrying some policy-makers at the sharp end of tackling the crisis: BOE Chief Economist Spencer Dale and Director of Financial stability Andrew Haldane have discussed the inadequacy of conventional models that exclude the role of the financial system in causing booms and busts; Adair Turner, chairman of the UK's Financial Services Authority, acknowledged that policy-makers failed to anticipate the dynamics of bank deleveraging and the impact this would have on the economy.

Mainstream economists have been so fixated on understanding ordinary business cycles that they ignored the role that years of rising asset prices and financial sector liberalisation can play in fuelling credit booms. They lost sight of the fact that the financial system does more than allocate resources: It creates money—and therefore purchasing power—every time it extends a loan.

For investors, the sensible response is surely to disregard all short-term forecasts based on out-dated models. They should focus instead on identifying those economies most likely to deliver a medium-term recovery by aggressively addressing their stock of debt. In the European context, it is the eurozone where the process of debt reduction and restructuring seems likely to proceed most rapidly, not least because the greater independence of the European Central Bank means there is less prospect of loose monetary policy being used to defer tough decisions.

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