Oh dear, oh dear, so wrong, so wrong

26 September, 2012 at 10:56 | Posted in Economics | 6 Comments

Mainstream economists often maintain – usually referring to the methodological individualism of Milton Friedman – that it doesn’t matter if the assumptions of the models they use are realistic or not. What matters is if the predictions are right or not.

If so, then the only conclusion we can make is – throw the garbage in the dustbin! Because, oh dear, how wrong they have been! 

Simon Potter has analyzed the predictions that the Federal Reserve Bank of New York did on the development of real GDP and unemployment for the years 2007-2010. The predictions had it wrong with respectively 5.9% and 4.4%  – which is equivalent to 6 millions of unemployed:

Economic forecasters never expect to predict precisely. One way of measuring the accuracy of their forecasts is against previous forecast errors. When judged by forecast error performance metrics from the macroeconomic quiescent period that many economists have labeled the Great Moderation, the New York Fed research staff forecasts, as well as most private sector forecasts for real activity before the Great Recession, look unusually far off the mark.

One source for such metrics is a paper by Reifschneider and Tulip (2007). They analyzed the forecast error performance of a range of public and private forecasters over 1986 to 2006 (that is, roughly the period that most economists associate with the Great Moderation in the United States).

On the basis of their analysis, one could have expected that an October 2007 forecast of real GDP growth for 2008 would be within 1.3 percentage points of the actual outcome 70 percent of the time. The New York Fed staff forecast at that time was for growth of 2.6 percent in 2008. Based on the forecast of 2.6 percent and the size of forecast errors over the Great Moderation period, one would have expected that 70 percent of the time, actual growth would be within the 1.3 to 3.9 percent range. The current estimate of actual growth in 2008 is -3.3 percent, indicating that our forecast was off by 5.9 percentage points.

Using a similar approach to Reifschneider and Tulip but including forecast errors for 2007, one would have expected that 70 percent of the time the unemployment rate in the fourth quarter of 2009 should have been within 0.7 percentage point of a forecast made in April 2008. The actual forecast error was 4.4 percentage points, equivalent to an unexpected increase of over 6 million in the number of unemployed workers. Under the erroneous assumption that the 70 percent projection error band was based on a normal distribution, this would have been a 6 standard deviation error, a very unlikely occurrence indeed.

In other words – these cocksure mainstream economists with their “rigorous” and “precise” mathematical models were wrong. And the rest of us have to pay for it.

About these ads