The central banks tell us their policies are data-dependent, but then they use that data to create models that are patently wrong time and time again. Trusting central bankers now, whether in the US, Europe, or elsewhere, is a dicey wager, given their track record. Unfortunately, the problem is not that economists are simply bad at what they do; it's that they're really, really bad. They're so bad that their performance can’t even be a matter of chance.
The reason is that they base their models on flawed economic theories that can only represent at most a pale shadow of the true economy. They assume they can use what are called dynamic equilibrium models to describe and forecast the economy. In order to create such models they have to make assumptions – and when they do, they assume away the real world.
It is not so much that the models I am criticizing are useless – they can offer economic insights in limited ways – but they cannot be (successfully) used to predict the economy or stock markets with anything close to certainty. They are simply not complex enough – and they cannot be made complex enough – to accurately describe the nonlinear natural system that is the economy.
Such models can at best give you insights into certain conditions that are limited by the assumptions you have to make in order to create the models. If you’re using your models properly, you understand their deep limitations. I freely admit to using models to gather as many insights as I can (especially about relative valuations), but I certainly don’t rely on them to actually predict the future. You should never use a model without understanding in a deep and all-encompassing way that past performance is not indicative of future results.
I’m concerned that, in the coming years, looking at historical data for guidance about the future will be more misleading than simply guessing would be. The times aren’t just changing; the very underlying economic conditions that produced past performance will no longer pertain. We are truly on economicus terra incognita. (Okay I made that one up, but you get the idea.)
If I were a young and mathematically gifted economist, I think I would explore the use of complexity theory to model the economy, based not on Keynesian nonsense or the hubristic assumption that an economy can ever be in a state of equilibrium (it can’t), but using Claude Shannon’s information theory instead as a better way to demonstrate how economics works in the real world (an idea brilliantly suggested by George Gilder in Knowledge and Power).
QE 4
So now that we’ve established that forecasting is worthless, let me make a forecast. When we next have a recession in the US, the Federal Reserve will give us QE 4. They are going to base their monetary policy on the data they have at the time, even though all their own research says that the last round of QE really didn’t do anything. They will once again push us into a world of financial repression malinvestment because they will feel the need to “do something,” and about the only thing they will be able to come up with is more quantitative easing. Which will force the world into yet another mutually destructive round of competitive currency devaluations. The image that springs to mind is that of a circular firing squad, with the participants being the world’s major central banks, some of which actually do have bazookas. As usual, the investors of the world will be caught in no-man’s land. (I hear the old tune by Martha and the Va ndellas starting to play in the back of my brain: “Nowhere to run to, baby, nowhere to hide….)
There is a significant part of me that now feels, or perhaps fears is the better word, that the Fed will embark upon an experiment with negative interest rates in the world’s reserve currency. One of the ideas that I want to explore at my conference this year is what the consequences would be of negative interest rates in the US and how we should deal with them. We will have a number of European financial experts in attendance, and I will pose the question to them. I am more interested in this prospect as a practical matter than as a theoretical one. If you are managing a client’s money in anything that looks like income ETFs or mutual funds, how would you deal with this? There are a number of different types of funds that are actually required to hold their excess assets and cash reserves in short-term Treasurys. Will regulators really make funds hold reserves in assets that force clients into negative returns? Seriously?
Why Forecasting Next Year Is a Crap Shoot