How useful are economists?

First most of them missed the degree of the recession, and now they can't agree on what to do. Having missed lessons of the Great Depression, some would argue that they've let the economy spiral out of control due to bad forecasts, an unwillingness to admit mistakes and an arrogance which suggests they're quite confident that most people consider economics to be beyond their own comprehension or control.

Yes, I'm talking about economists, and they're the subject for a BusinessWeek magazine cover story entitled "What good are economists anyway?"

Of course many bloggers and a few economists -- such as Christopher Thornberg, a partner to MetroIntelligence -- were warning of a great housing bust and a recession to follow as early as 2004, but such voices were largely drowned out by a cheerleading press and a dishonest NAR economist named David Lereah, whose objectivity was rarely questioned.

So where did these economists go wrong and what lessons should we learn from their profound mistakes? From the story:

Economists mostly failed to predict the worst economic crisis since the 1930s. Now they can't agree how to solve it. People are starting to wonder: What good are economists anyway?...

To be fair, economists can't be expected to predict the future with any kind of exactitude. The world is simply too complicated for that. But collectively, they should be able to warn of dangers ahead. And when disaster strikes, they ought to know what to do. Indeed, people pay attention to economists at times like this precisely because of their bold claim that they know how to prevent the economy from sliding into a repeat of the Great Depression. But seven decades after the Depression, economists still haven't reached consensus on its lessons. The debate has only intensified in recent weeks...

The rap on economists, only somewhat exaggerated, is that they are overconfident, unrealistic, and political. They claim a precision that neither their raw material nor their skill warrants. Too many assume that people behave like the mythical homo economicus, who is hyperrational and omniscient. And they take sides in quarrels that freeze the progress of research. Those few who defy the conventional wisdom are ignored...

Click here for full story.

Should economists be ranked on their correct calls?

One of the greatest battles that economic and development consultants face is competing against those who really don't know what they're doing, but simply market and present well. I've been in meetings where you could almost scrape the BS off the wall, but everyone else in the room seems to be nodding (or sleeping?) without so much as a penetrating -- and therefore inconvenient -- question.

This is why I've been suggesting that when a large real estate project goes belly-up, a team of analysts should comb through the due diligence package to determine if it was simply larger market forces at work that would have torpedoed the best of plans (which is common), or if it was a collection of smoke and mirrors from the outset through which a high schooler of average intelligence could see.

Apparently Newsweek writer Joseph Epstein sees the same problem among economists, and has suggested that this group of experts, like baseball players, be subjected to a rating system based on how many times they get it right. From his article:

One of the not inconsiderable side effects of the current economic meltdown is the demise of the economic expert, if experts they truly ever were...

This might be a touch more forgivable if economists, as a profession, didn't specialize in displaying such relentlessly high confidence. I first picked up on this many years ago when watching John Kenneth Galbraith and Milton Friedman in debate. Here were two men who could not be brought to agree on the weather, but the one trait they shared was supreme confidence, each in his own absolute correctness. I have never met an economist whose demeanor suggested he harbored the least bit of doubt...

When economists appear on television, they ought, like baseball players in the batter's box, to have their averages (how many times they have been right, how many wrong in their prognostications) shown in a crawl beneath their confident faces...

After being wrong so often during the current crisis, an unseemly humility is beginning to show up in economists. On television, Liz Ann Sonders, the chief investment strategist for Charles Schwab, recently said, "Look, I would love to know where we go from here, but no one does."

Warren Buffett, the great economic guru of the Prairie, whose Berkshire Hathaway company has lost more than 30 percent of its value, suddenly seems a lot less godlike. Ben Bernanke, the head of the Federal Reserve, comes on as anything but super-confident in the grand old economistic style...

Ah, yes, the mysteries of life—the passions, the envy, the greed, the mischievous second hand undoing the supposedly careful work of the invisible hand of the market, the unpredictable everywhere scrambling those best-laid plans.

All this has been playing out, leaving chaos in its wake, while the gods of fate and destiny bend over the table, sly smiles on their faces, utterly heedless of the pathetic predictions of the once haughty economists, until now so happy in their work—leaving the rest of us to fight through the current crisis as best we are able without benefit of their deeply flawed advice.

Exactly. Aside from the guys at Beacon Economics, of course, who DID get it right before the bubble(s) burst.

200 economists sign petition against quick bailout plan

Lately most of the anti-bailout rhetoric I've seen has been from people commenting on blogs, with most economists quoted in the MSM in favor of it. So why haven't the 200 economists who have signed a petition against the existing bail-out plan been widely quoted? I guess that's a question for the media. From a member's website:

To the Speaker of the House of Representatives and the President pro tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America's dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

Click here to see the list.

Economists differ on how to value housing

One of the main reasons that I think economists can't seem to agree on how to value the appropriate price for housing is because they tend to take a 30,000-foot view, sort of what you might see when flying over an area. Then, taking out their magic pencils, they wave it over the area and proclaim that prices must fall by a certain amount in order to revert to a long-term relationship between prices and median incomes, or prices versus potential rents, or prices versus changes in interest rates.

Of course real estate agents will tell you that since real estate is local that the 30,000-foot view is inherently flawed, thus giving us one more reason that no one can seem to agree on a home's value -- other than comps, of course, which of course only tell you what a home in the same area recently sold for and may or may not have anything to do with your house.

So what's a home buyer or home seller to do? Fortunately, a story in the New York Times (hat tip: Patrick.net) lays out the various metrics economists use to value real estate markets and the pros and cons of each:

The New York Times asked economists across the country to share the data they use to figure out how much houses in regional markets are overvalued, a calculation that approximates where the bottom may be. Models built on these variables show that while some markets — such as California — are on a road to recovery, others — such as south Florida — have a way to go.

These signs cannot possibly tell the whole story, especially since they point more toward where prices should be valued than where they will be. But these measures are nonetheless helpful to anyone buying, selling or borrowing against their home sweet home...

One way to envision the bottom would be to look back at where prices were five or 10 years ago, before the current price run-up. There are some better ways, though.

Noting that home prices have outpaced inflation in the past, one can calculate how much houses appreciated annually in the decades before the bubble, and then figure out how far out of line prices are now. Edward E. Leamer, director of the U.C.L.A. Anderson Forecast, has crunched these numbers for various regional markets.

In Ocean City, N.J., for example, inflation-adjusted house prices rose about 1.6 percent a year from 1988 through 2002. Compared with what this rate would predict, the city’s houses in the first quarter of this year were overvalued by 51 percent. Over the previous year, they had fallen 0.6 percent; at this pace, Ocean City house prices will be at the right level in about 13 years. The model foretells eternal decline for some cities. It predicts that Kingston, N.Y., will not return to “normal” for almost four centuries.

So that's not very helpful, is it?

Many experts look to price-to-rent ratios to estimate where house prices should be in a region. Because renting is a direct alternative to buying, and because rents tend to be less volatile than prices, rents are often considered to be a good shorthand for figuring out the intrinsic value of a home.

In the past decade, the price-to-rent ratio in many markets has exploded, indicating that people have been paying much more for their homes than the property is actually worth. From 1994 to 2002, for example, Phoenix had an average ratio of 11, according to data from Moody’s Economy.com. After peaking in the last quarter of 2002 at 22.5, it cooled to about 17.3 in the first quarter of this year.

This measure is popular but problematic because some economists say many of the homes that people rent (apartments in multifamily buildings) may not be comparable to the types of homes that people buy (single-family houses).

This is why looking at the local market is key -- that way you'd have a much better chance of finding a comparable property for rent. Any economist who would compare the cost of renting an apartment with the cost of owning a single-family home to argue for lower home prices should give back his PhD.

Another ratio that housing economists watch is the ratio of home prices to per-capita income. This is telling because it shows whether Americans can actually afford the houses in their area.

Looking at previous peaks and troughs in the income ratio can provide an idea of where the housing market will bottom in a particular city. In Boston, for example, the housing market peaked in the late 1980s around 11, and then hovered around 7.5 when it bottomed in the late 1990s, according to Mr. Case. This time around, it peaked at over 12, and in the first quarter of this year, it was just over 10...

Some economists argue that the price to per-capita income ratio is misleading, because the price used in that model does not take into account the full cost for buyers. This full cost should include not just the price of the house but mortgage rates as well.

“As long as anyone can remember, as long as we have data, mortgage rates have been about 1.6 percent above the 10-year Treasury rate,” said Christopher J. Mayer, an economist and senior vice dean at Columbia Business School. “Today, it’s more like 2.5 percent above the 10-year Treasury. That’s a gigantic difference, literally reducing the amount of house someone could afford by 20 percent.”

He has put together, in a model that has not yet been published, a rough calculation of where house prices should be if mortgage markets were functioning the way they had been in the last few decades.

This model shows that big-bubble cities like Miami and Phoenix were still overvalued in the range of 13 percent in May. It also found that San Francisco and Boston homes were corrected to the right level, and that homes were actually undervalued in New York by 5 percent.

Still, Mr. Mayer says prices in these cities will probably continue to fall because of deteriorating mortgage markets and economic fundamentals.

Yet another ratio worth watching is the relationship of housing inventory to sales. This measures the imbalance between supply and demand, which is the economist’s holy grail of market behavior.

A recent International Monetary Fund paper argued this measure was the strongest determinant of housing prices in the short run. Booming areas were often overbuilt and have the most inventory to clear out before prices can recover. Inventory-to-sales ratio declines across California, for example, have given hope that the state is nearing recovery...

The wrench in all these models is that this is the first national housing bust since anybody started keeping track of many of these useful data points. It is hard to predict how the national trends will affect state and city housing markets, which are otherwise very local organisms...

...some experts argued that it was silly to try to build a mathematical model for the market’s overvaluation. Too much is unknown, they say, to make any predictions.

Economists debate depth of downturn

A v-shaped recession? U-shaped? How bad will it be? Will it turn into a depression? At this point, a depression is unlikely, at least according to a group of economists contacted for a story in the New York Times (via Patrick.net):

Even if the economy continues to deteriorate, economists generally agree that the United States is not heading for another Great Depression. Not only are the conditions far less dire, eight economists said in interviews, but the government is playing a heightened role in trying to cushion the impact of the housing downturn, losses at financial institutions and rising unemployment.

“The government is larger now and it acts as an anchor,” said Richard Parker, senior fellow at the Shorenstein Center at Harvard. “During the Great Depression, the government had neither the means nor the capability to serve as a backstop.”

But the economists — who range from academics to policy researchers, liberals to conservatives — disagreed about just how bad this economic slowdown, led by the worst housing slump since the Depression, could be...

Most of the economists who were interviewed blamed Alan Greenspan, the chairman of the Federal Reserve from 1987 to 2006, for his unwillingness to clamp down on either the technology stock bubble or the run-up in housing prices.

“The Fed isn’t the whole story, but it’s a big part of it,” said Gerald P. O’Driscoll Jr., who was vice president of the Federal Reserve Bank of Dallas from 1982 to 1994 and is now a senior fellow at the Cato Institute, a libertarian research organization in Washington. “It allowed these absolutely insane bubbles to happen. The lesson is, you can’t let these bubbles continue unabated with no policy making.”

But the economists said others were to blame, too: investors, banks and rating agencies, as well as the current chairman of the Federal Reserve, Ben S. Bernanke, and the Clinton and Bush administrations...

The economy’s woes might have been preventable, the economists all agreed, if the actors involved had made more realistic assumptions about the future. And about the laws of gravity.

“People are way too willing to extrapolate from history,” said Jan Hatzius, chief domestic economist at Goldman Sachs. “If it’s 2005, you can’t look at a 40-year run of data and say, ‘It must be a law of nature that housing prices never fall.’ ”...

All the economists agreed that regulators should have been looking more closely at Fannie and Freddie.

“Everybody turned a blind eye,” Mr. O’Driscoll of the Cato Institute said. “The Fed deliberately and consciously refused to regulate the mortgage industry like it was supposed to have done. I’m not a big fan of government regulation, but sometimes the government can do something to help — and in those cases, it has to.”

Ah, the power of 20/20 hindsight.