Toward a Revolution in Macroeconomics
Douglas, Heman Cortes, The World and I
Hernan Cortes Douglas is a Luksic Scholar at Harvard University, David Rockefeller Center.
"This expansion will run forever." So said an MIT distinguished professor of economics, in an article published in the Wall Street Journal.1 Think about it. A respected leader in the field comes to a conclusion about economic behavior that defies the entirety of history. As that article appeared on July 30, 1998, we know that its conclusion also failed to accommodate the future, but his opinion was not unique at the time. Ninety-eight percent of economists in the Wall Street Journal's New Year's poll of 2001 said they expected continued expansion throughout the year. Only three months later, the recession began.
This type of forecasting error is hardly a first for macroeconomists. Examples of the profession's failure to anticipate economic contractions are legion and span its entire history. The Economist reiterated in its November 29, 2001, issue, "Economists have a dismal record in predicting recession." Some instances have been so glaring and instructive that they beg retelling.
A BRIEF REVIEW OF MAJOR FAILURES IN ECONOMIC FORECASTING
To most famed and respected economists of the 1920s, the crash that preceded the Great Depression was utterly unexpected. Fourteen days before Black Tuesday, October 29, 1929, Irving Fisher, America's best- known economist and professor of economics at Yale University, declared, "In a few months I expect to see the stock market much higher than today." Fisher, a consummate theoretician, founder of econometrics, and pioneer in index number analysis, was also a successful capitalist, having invented the c-kardex file system, which he sold for a staggering sum. He had such faith in his economic analysis that he is reported by his son to have lost an estimated 140 million of today's dollars in the crash.2
British economist John Maynard Keynes, the renowned father of macroeconomics, had amassed fortunes in the financial markets for both himself and Cambridge University. He too was caught unprepared, shedding 1.2 million of today's pounds sterling of his net worth.3
Days after the crash, the Harvard Economic Society reassured subscribers that "a severe depression such as 1920--21 is outside the range of probability. We are not facing a protracted liquidation." In 1932, after a string of failed optimistic forecasts, the society closed its doors. New societies--at universities, central banks, and independent "think tanks"--have since sprung up. Do they know any more about macroeconomic forecasting than their predecessors did?
Since the Great Depression, there have been immense improvements in science and technology. Given seven additional decades of data collection and progress in econometric techniques, one might presume that the forecasting tools of macroeconomics have become vastly more effective than their predecessors of 1929. Yet as recently as 1988, some leading economists went on the record about the profession's lack of progress. Writing in the American Economic Review, the journal of the American Economic Association, Kathryn Dom'nguez, Ray Fair, and Matthew Shapiro reported that a modern economist, armed with the latest and most sophisticated econometric techniques, and even using voluminous data that were unavailable in 1929, would have had no idea in 1929 that the Great Depression lay around the corner.
Real results continue to bear out the implications of this conclusion. For example, as one writer observed, "It is hard to imagine any article with worse timing than, say, 'Asia's Bright Future,' "4 which appeared in the November/December 1997 issue of Foreign Affairs. The article, by two Harvard professors, appeared as East Asian economies were already melting down and as Japan was staggering through one of the three recessions it has suffered in a decade of financial difficulty. Consider its disutility in light of the fact that 1974, a full twenty- three years earlier, would have been the best time for such a forecast, while 1997, late 1997 at that, was the worst time since the onset of World War II to have made it. …