Saturday, November 03, 2012

On the Central Planner’s Forecasting Failures

Do central planners have detailed or accurate knowledge about the workings of the markets and the economy? 

From Bloomberg,
The Bank of England’s forecasting capabilities have deteriorated in the past five years, resulting in “large” errors, and officials should investigate the reasons for such shortcomings, an independent review said today.

The report by David Stockton, a former Federal Reserve official, sets out options including encouraging “more assertive” staff to challenge the central bank’s “house view” and incorporating financial-stability risks into forecasts. It said the latter should be “high on the agenda.”

The review is one of three commissioned by the central bank’s governing body following a lawmaker push for an inquiry as the BOE prepares to take on unprecedented powers to regulate the financial system. The bank also released reports on its framework for providing liquidity to the financial system and its emergency support to banks.

“The Monetary Policy Committee’s recent forecast performance has been noticeably worse than prior to the crisis, and marginally worse than that of outside forecasters,” Stockton said. “The bank and the MPC need to introspect more deeply and more systematically about the lessons that can be gleaned from episodes of large forecast errors.”
Even a recent study from the US Federal Reserve of St. Louis questioned the debt and deficit forecasting capabilities of the Congressional Budget Office (CBO) whose “projections for longer horizons are considerably worse than those for shorter horizons”

Of course one can’t resist pointing out the astounding blindness of US Federal Reserve Chairman Ben Bernanke’s to the onset of the crisis of 2008 which continues to linger or haunt the US and world economies, today.

The central planner’s fundamental mistake emanates from the dependence on the supposed accuracy of the substitution or the simplification of knowledge through numerical aggregates based on econometric-statistical models for what in real life is a complex world operating on decentralized knowledge from human action from a combination of localized knowledge or “particular circumstances of time and place”, the individual’s unique and immeasurable preferences and value scales, economic calculation and the dynamic stimuli-response/action-reaction to the ever changing environment.

In accepting the Nobel Prize, the great F.A. Hayek explained of the pretense of knowledge by so-called experts
It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences — an attempt which in our field may lead to outright error. It is an approach which has come to be described as the "scientistic" attitude — an attitude which, as I defined it some thirty years ago, "is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed." I want today to begin by explaining how some of the gravest errors of recent economic policy are a direct consequence of this scientistic error.
If central planners have been blatantly, consistently and pathetically wrong with their economic forecasting—stemming from erroneous assumptions, premises, theories or models—then what more should we expect of the consequences derived from policies grounded on these wrong projections?

Black Swan theorist and author Nassim Taleb warns about mistaking centralization for stability (Foreign Affairs):
Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These arti´Čücially constrained systems become prone to "Black Swans" -- that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.

Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.

Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same misperception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open -- fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying...
Social policies aimed at ‘suppressing volatility’ which ultimately ends up with ‘massive blowups’ signifies as bubbles in motion are the risks we all envisage considering the path towards centralization (for instance, EU’s political union, bank supervision, expansive financial regulation)  undertaken by most developed economies.

Bottom line: I would not trust an iota of what central planners say.

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