Monday, Aug. 27, 1984

The Forecasters Flunk

By John Greenwald

Poor predictions give once prestigious pundits a dismal reputation

"I'm thinking of quitting and becoming a hockey goalie."

Lawrence Chimerine, chairman of Chase Econometrics, could be speaking for the entire fraternity of economic forecasters. After their failure to foresee the current economic boom, trying to block slap shots might seem like an easier career. Almost with one voice, the experts a year ago predicted moderate growth and a rise in inflation in 1984. They were spectacularly wrong. The U.S. economy has since embarked on a boom that has produced a stronger expansion with steadier prices than at any other time in the past two decades. In the first quarter of this year the gross national product grew at a dazzling 10.1% annual rate, more than twice what the experts had predicted.

Other forecasts have scarcely been better. The economists missed the onset of the 1981-82 recession, the worst downturn since the Great Depression. Then, once the slump arrived, they misjudged both its length and its severity. Now even some professionals have soured on economic predictions. Says Martin Feldstein, who returned to Harvard last month after an embattled 21 months as chairman of the President's Council of Economic Advisers: "One of the great mistakes of the past 30 years of economic policy has been an excessive belief in the ability to forecast."

Doubts about predictions popped up again last week when the Reagan Administration gave its midyear forecast of the economy and the outlook for the size of the federal deficit. Guided by figures produced by economists at the Treasury Department, the Office of Management and Budget and the Council of Economic Advisers, the White House estimated that the G.N.P. will grow by 4% annually between now and 1989 and that, as a result, the deficit will shrink from $174 billion in 1984 to $162 billion during that period. The G.N.P. projections, though, were so vague and uncertain that Treasury Secretary Donald Regan said, "If you believe them, then you also believe in the tooth fairy. I don't think that anybody can see very clearly for five years." Indeed, the Congressional Budget Office expects the deficit to swell to $263 billion by the end of the decade.

This kind of professional performance is raising serious questions about the degree to which companies and governments should pay attention to economists at all. "We have often claimed more than we can deliver," concedes Milton Friedman, the 1976 economics Nobel laureate. Partly in view of that, Neoconservative Pundit Irving Kristol has argued that the Swedish Royal Academy of Science should stop awarding the Nobel Prize for Economics. Says Economist Lester Thurow of the Massachusetts Institute of Technology: "Economics is no longer in fashion. In the U.S., the public esteem of economists is lower than at any time since World War II."

That is nowhere more true than in the White House, where President Reagan, an economics and sociology major at Illinois' Eureka College, seems to prefer to be his own economist. Reagan is not bothering to fill the top economic advisory post vacated by Feldstein until after the November election, assuming that he is reelected. According to Murray Weidenbaum, Feldstein's predecessor, Reagan once asked, "Do we need a Council of Economic Advisers?"

For his part, Democratic Presidential Nominee Walter Mondale has been keeping economists out of the campaign spotlight. He has, however, been quietly consulting a circle of liberal economic thinkers, including Walter Heller, a fellow Minnesotan and the top economic adviser to Presidents Kennedy and Johnson, and George Perry, a senior fellow at Washington's Brookings Institution.

The prestige of economists has also been tumbling among corporations. Robert Lohr, a Bethlehem Steel executive, blames his firm's $768 million operating losses in 1982-83 partly on "the investments we made because we believed in the boom of 1981 that an economist promised us." AMAX, a major metal mining concern (1983 sales: $2.4 billion), dug itself an $879 million hole over the past two years by heeding forecasts of continuing inflation. Those projections led the company to assume that the prices of its copper, molybdenum and other metals would keep rising. Instead, their market value has fallen 50%.

Faced with such debacles, some companies have been trimming the size of their economics staffs. "A lot of capital goods makers got rid of their forecasters," says Pierre Rinfret, a Manhattan economic consultant. General Electric (1983 sales: $27 billion), whose products range from light bulbs to locomotives, has slashed its economics division from about two dozen economists to twelve since 1979. United Technologies ($17 billion) now has just one economist, while RCA ($8.9 billion) has had none since 1976.

Whether they work in companies or as consultants, many economists get their predictions from mathematical models of how the U.S. economy is presumed to work. The largest and most powerful models, owned by Chase Econometrics, Data Resources and Wharton Econometrics, contain some 1,000 equations that attempt to predict future business performance on the basis of past developments. The models, for example, look at the effect interest rises have previously had on housing starts and then forecast what would happen if rates go up again. To use the models, economists crank in the latest Government statistics and, Presto!, out comes the future. Clients pay anywhere from $10,000 to $30,000 a year for forecasts from those firms, and then often have their own economists evaluate the results.

The only trouble is that the models assume that people will act tomorrow pretty much the way they did yesterday. Yet the public's reaction to economic developments often changes dramatically. A person may save a large chunk of income one year when inflation is 12%, but splurge on a new car or a trip to Europe the next time prices are rising that fast. A cautious executive may hesitate to build a new factory, while a more aggressive manager, facing similar conditions, may decide to invest. One reason forecasters missed this year's boom is that they failed to realize how much the recession had dammed up the demand for housing and other items. When good times arrived, people began spending much faster than expected.

Such oversights have led critics to charge that many forecasters are too preoccupied with mathematics to see what is happening in the real world. Says Consultant Rinfret: "Economists prefer mathematical models because they are elegant and orderly. But markets are never neat and orderly. They are full of surprises." As indeed are people. Wassily Leontief, winner of the 1973 Nobel Prize for Economics, bitterly complains that "economic journals are filled with mathematical formulas leading the reader from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions." Economists, says Leontief, are "great bores" who operate in "splendid isolation."

The stress on mathematics, which makes a large part of economics incomprehensible to laymen, is a relatively modern development. Adam Smith, David Ricardo and other founding fathers of economics were far more concerned with broad social and political issues than with numerical precision. Says Economist Robert Heilbroner: "They were worldly philosophers who turned out to be great visionaries." But as the discipline developed, the interests of many researchers grew narrower. "We have almost reached the point," says M.I.T.'s Thurow, "where if you can't quantify it, you can't say it."

Mathematical economists have longed to turn their field into an exact science that could predict business developments as precisely as Sir Isaac Newton was able to set down the laws of motion. "Economics inserted itself into the determinist universe of Newton," says Herbert Giersch, director of the Institute for World Economics in West Germany, "in order to gain dignity as a science." That effort has led not only to econometric models but also to elaborate mathematical systems with few practical applications. Last year, Gerard Debreu, a University of California, Berkeley, economist, won the Nobel Prize largely for a purely theoretical description of a perfectly functioning economy.

Perhaps because Americans love gadgets and instant answers, the trend toward mathematical economics has taken hold more firmly in the U.S. than abroad. In Europe, the birthplace of economics, practitioners have more often maintained a philosophical attitude (see box). Says British Economist Samuel Brittan: "I do not think Europeans were ever as credulous, and they have been less impressed by numbers." The prestige of economists has thus not sunk as far in the Old World as it has in the U.S., since it was never as high to begin with.

In America, the 1960s were a golden age for economists. The period was relatively free of economic turmoil, and under Heller's tutelage, the Kennedy Administration proposed and the Johnson White House put into effect a tax cut that worked precisely as promised by spurring growth without aggravating inflation. The success of that policy was a striking victory for the theories of John Maynard

Keynes, who held that deficit spending could pump up a slack economy. Johnson later balked at the pleas of his Keynesian advisers to pay for the Viet Nam War with higher taxes in order to keep the economy from overheating and pushing up prices. Nonetheless, so prestigious had Keynes' views become that even Republican President Nixon could declare in 1971, "I am now a Keynesian."

But the woes of the '70s shattered the esteem in which Keynes had been held. Reeling from two energy crises, a severe recession and other shocks, the economy began to behave in ways that the experts had once thought impossible. Most disturbing, high levels of inflation and unemployment came together in a painful new ailment dubbed stagflation. Keynesian prescriptions seemed only to make that malady worse.

The troubled decade left U.S. economists in brawling disarray. The monetarists, who stress the importance of gradual growth of the money supply to a sound economy, and Keynesians set up a clamor of conflicting claims. Members of the rational-expectations school argued that deficit spending could not work over the long run. And a small but vocal group of economists known as supply-siders called loudly for incentives to save and produce.

To add to the confusion, each school makes use of economic models that reflect its pet theories. Some supply-side predictions have been overly bullish, for example, while the Keynesian and monetarist outlooks have mostly been too cautious.

Says Economist Robert Eggert, who compiles 46 forecasts in his Blue Chip Economic Indicators: "The model that would probably work best would be a combination of supplyside, Keynesian and monetarist views. But it exists only in the forecasters' heads."

In the war among economists, conservative thinkers now seem to be ahead. Says Harvard's Feldstein: "All mainstream practitioners are more monetarist, more supply-side oriented, and less Keynesian today than they used to be."

Still, Nobel Economics Laureate James Tobin, an outspoken Keynesian, can persuasively describe the current boom as _ mainly a result of deficit spending. Far from being a supply-side victory, he says, the recovery represents "an accidental and classic Keynesian dose of fiscal and monetary stimuli."

But for all their conflicts, economists still share a surprisingly large number of views. "Our disagreements have actually become much smaller,"says Friedman, the leader of the monetarist school. Virtually all economists espouse free trade, and most would analyze a wide range of policy prescriptions in similar ways.

Forecasters also like to point out that while people may rem member bad predictions, they tend to forget the times when projections have been right.

Lawrence Klein, winner of the 1980 Nobel Prize for pioneering the development of modern econometric models, is proud of his Wharton forecasts. They correctly predicted that the 1973 Arab oil embargo would result in a recession and higher inflation, and that the 1981 tax cuts would swell the federal budget deficit far beyond Government estimates. Says Klein: "At least econometric models can give you a quick on-line response to any major event like an embargo or a change in fiscal and monetary policy."

Critics concede that forecasting has its place. "Whether we like it or not," Spanish Philosopher Ortega y Gasset once wrote, "human life is a constant preoccupation with the future." Indeed, though bad predictions have hurt companies like AMAX, its chairman, Pierre Gousseland, still believes in trying to look ahead. Says he: "Economists are as essential to conducting your business as meteorologists are for anticipating weather patterns. The alternative would be flying blind." But even when the weatherman forecasts sunshine, a cautious person may take along an umbrella. Executives should be no less skeptical when listening to their economists. --By John Greenwald.

Reported by Frederick Ungeheuer/New York

With reporting by Frederick Ungeheuer