Economics and the Great Recession

So what is really happening to the U.S. economy? Is it in recovery mode, or did the very negative growth numbers for the first quarter signal a new recession? Is the European economy in a recover phase, or not?

While I have firmly said “no” on the European recovery question, there is no doubt that economists in general will wrestle with these questions for at least the remainder of 2014. The past few years have been particularly challenging for economists, especially those whose days are spent on mainstream, econometrics-based forecasting. In an excellent article for the Wall Street Journal, republished by the Hoover Institution, financial economist John Cochrane shows just how challenging those years have been.

Put bluntly, over the course of the Great Recession, leading macroeconomists have missed the target in their predictions of GDP growth by so much that if they tried to send a space chip to Mars it would go to Jupiter instead.

Fortunately, economists do not build space ships. But major errors in macroeconomic forecasting are a serious matter. Politicians decide fiscal policy based on those forecasts. In Greece, for example, the government followed advice on tax increases and spending cuts from leading economists at the International Monetary Fund (IMF). The IMF economists had grossly under-estimated the negative reactions in the private sector to government spending cuts.

The error, concentrated to a so called fiscal multiplier, was of such dimensions that one fifth of all young in Greece are now unemployed indirectly as a result of that forecasting error.

As I have reported before, IMF chief economist Olivier Blanchard, a highly respectable economist, issued a full mea-culpa paper soon after they discovered the error. The paper is a stark but honorable warning to other economists to be more cautious about forecasting the future – and about offering legislative advice.

As a macroeconomist I have great difficulty discouraging anyone from listening to advice from economists. Generally, we do well on the policy side. But the Great Recession has challenged a lot of widely held beliefs in economics, among them the belief that econometrics – currently the technical core of economic forecasting – is the supreme tool for predicting the future.

Unorthodox economists like yours truly have long criticized mainstream economists for relying too much on so called rigorous quantitative tools. As Cochrane’s article shows, this debate is gaining strength, and it is a safe bet that it will continue for a long time. In fact, I believe it will constitute the groundwork for major reforms to macroeconomics, both in theory and in methodology, over the next decade or two.

We need those reforms, and we all need to pull our load to make them happen. I do not pretend to have a big voice, but my new book, Industrial Poverty, about the European crisis, will be my first contribution to the conversation.

Politicians, businesses and other members of the general public depend on us knowing what we do. If we are not willing to reconsider our theory, our methodology and everything else all the way down to our forecasting methods, then economists will ultimately be responsible for more surprises in the future, like the one with the U.S. growth numbers, or the one that has been unfolding in Europe over the past five years.