Ten things people will say economists said

Over at the Big Picture they are discussing how silly the decoupling thesis is (the idea that that world economic growth now functions separately from US economic growth). Near the end they mention ten things that seemingly intelligent people have said, that have turned out to be complete rubbish, namely:

  1. The Yield Curve no longer matters
  2. Earnings at an unusually high % of GDP are sustainable
  3. The Business Cycle has been defeated
  4. Ignore sentiment readings, the population is just upset about Iraq
  5. Real Income gains are irrelevant
  6. Mean reversion no longer applies
  7. Supply side tax cuts pay for themselves
  8. Dow Theory is a quaint antiquity
  9. The (so-called) Fed Model “proves” equities are significantly undervalued
  10. Despite commodity prices, there is no Inflation.

Now people love to accuse economists of saying these thing, however I do not know any economists that have said any of this (or anything close to it).  If you can think of any economists that said these sorts of things, link to them in the comments so we can have a closer look at their arguments.

It is important to remember that in New Zealand, both public and private sector forecasters have been criticised for forecasting growth that is ‘too low’ for so long, and now as soon as it does slow, we get criticised for not telling everyone exactly when it was going to happen!  Economists can predict directions, but no-one can consistently pick turning points, so I think generally many forecasters did a good job 🙂

One thing we do know is that the longer a slowdown takes to occur, the worse it will be – not a particularly good thing to hear after five straight years of strong world economic growth.

Does this mean its time to panic (like the Fed already has to some degree), well no.  Anyone who has done first year economics will remember that booms and busts are all part of the business cycle, its not the end of the world (contrary to popular opinion).  A few economic fundamental are out of whack, and we need a time of readjustment before we can focus on further economic growth.  In the US government and monetary policy should focus on limiting the depth of the recession, without causing more financial market moral hazard.

New Zealand is well positioned with a strong fiscal balance sheet, a low unemployment rate, and high commodity prices which will now be partially entrenched through international contracts.  However, we remain vulnerable in terms of our large balance of payments deficit and a relatively high level of entrenched inflation expectations.  Personally, I’m going to be watching commodity prices – although milk might ease a little further, new biofuel legislation around the world is likely to give beef (and possibly lamb) a boost through 2008.

Even in the worst case scenario, when the US economy goes into a full blown recession (two quarters of negative growth), we will see commodity prices fall – including oil.  The exchange rate will fall (as we have a large balance of payments deficit), and the Reserve Bank has plenty of scope to lower interest rates.  Our banking system is in great condition, ensuring that there will be a reasonable amount of liquidity, at least for consumers, in the New Zealand economy.  My main concern would actually be relatively tight firm profit margins – if firms keep struggling to pass on costs then they will have to lay people off, or even shut down.

  • CPW

    Well according to my business card I’m still an economist, and I’m quite happy to sign up to:

    1. – Not certain what this means? That an inverted yield curve always signals recession? Trueish in the US but a complete fiasco in the NZ context, so I don’t know if I would say this utterly wrong.

    2. – I’m not aware of economic models suggesting that there is a long-run value (as a share of GDP) that earnings must revert to. Normal technological shocks or shocks to labour supply could permanently shift the share.

    3. – Not defeated but the fact we’re living in the the “great moderation” is conventional wisdom still I believe.

    4. – Consumer confidence has a little bit of predicative power, but is hardly the be-all and end-all.

    6. – As per 2, mean reversion in p/e (or similar) ratios has been a stylised fact of historical equity market data, but there is no reason that structural shifts couldn’t occur.

    7. – I wouldn’t agree to this but would add the the words “at prevailing tax levels” for clarity.

    8. – Dow theory is the usual technical analysis mumbo jumbo, with very little evidence to support it whatsoever. You’d have a much harder time finding an economist who didn’t agree with this statement.

    9. – The fed model is just another way of justifying the belief that p/e ratios earnings mean revert, so this isn’t consistent with 6 really. Of course the fed model doesn’t prove that shares are underpriced, it suggests that either shares are underpriced or earnings are overestimated. Looks like the latter right now…

    10. – Plenty of economists are satisfied with the evidence that short-term price movements in volatile components like commodities don’t have any predictive power for future inflation, and hence should be ignored (by looking at core inflation). So not an outrageous position at all, unless commodity price changes are undergoing a longer term trend. But even then, if commodities are imported, is there any value in trying to push the non-tradable sector into deflation to offset the tradable inflation?

    On another note, just because there has been a business cycle historically doesn’t mean we should be relaxed about recessions. I still think they’re a complete waste, with very few benefits. I’m not even convinced the US needs to undergo much in the way of reallocation of resources, the decline in building is (probably) mostly over already. It strikes me that a US recession would be a completely pointless Keynesian-type demand slowdown, for no good purpose (unless you think Americans should be saving more…).

  • Those comments generally seem to be variations of, ‘this time it’s different’; perhaps the greatest bullshit statement of them all (or so the ex-girlfriends of my serial philandering friend have found out).

    While I agree with CPW’s point that the norms can change in the long-run, statements of the ilk of those you’ve listed are attempting to explain things that have so far only proven to be short term phenomena.

  • CPW, I agree with most of what you said. My two problems (which is really one problem) are with the mean reversion and business cycle business. People tend to see a boom and forget that their is a downside, the business cycle will never be defeated, its a natural part of the economy. I completely agree that the ‘mean’ is shifted around by supply side factors (the real business cycle doctirine), however animal spirits will always drive around the demand side of the economy causing a cycle.

    Peoples determination to explain all upward shifts in growth on supply side effects drives me nutty – no doubt supply side shifts are a major driver, but a business cycle will always exist.

    “this time it’s different”

    I find that statement annoying as well Richard. Its not wrong, things are always different, but what people mean when they say it is often bull.

  • CPW

    I agree, “this time it’s different”, is usually a good warning sign. But to address the main claim on corporate earnings, I would of thought that a rising income share is a quite plausible response to the shock to global labour supply arising from globalisation. It’s possible (don’t know the US tax situation well enough) that some of the increase was simply income shifting following the tax cuts in early 2000s.

    On mean reversion, well draw the trend through any random walk and it will look like the series mean reverts even when we know it doesn’t. There’s still not really a sound explanation for why shares have returned such a high premium historically over risk-free assets, it’s not implausible that people could gradually overcome their risk aversion, driving down shares’ risk premium and pushing up the prices and p/e ratios.

    If I had total faith in mean reversion of yield ratios I would be pretty scared about NZ house prices right about now…