Posted 9:33 AM by Robert

The Bad Economist? II: Some Problems With Predictions

The sorrows are not new. That is, the sorrows of aging enfant terrible Herr Doktorprofessor Paul Von Krugman with economic forecasting that recently brought him to the absurd and humiliating position of writing in late July, almost one full month into the third quarter for which the GDP growth rate is now known to have been 8.2% and non-farm business productivity rose at 9.4% annual rate, that There is very little evidence in the data for a strong recovery ready to break out.

Richard Posner, one of the countries best federal judges and a leading light in the application of economics to law - wrote of Krugman in Posner's book Public Intellectuals: A Portrait of Decline:

He was not hired by the Times for his record as a prophet. In a book published in 1990 [The Age of Diminished Expectations: U.S. Economic Policy in the 1990s] he had offered as 'the most likely forecast for the U.S. domestic economy in the 1990s...fairly slow growth, modestly rising incomes for most Americans, generally good employment performance, [and] a gradual acceleration of inflation' to 7 percent. He predicted that by 2000 the United States would "have sunk to the number three economic power in the world," after Europe and Japan, and that the world economy would be less unified than it had been in the 1980s. He published a "revised and updated" edition four years later, but retained these predictions.

These dud predictions lie at or near the heart of Paul Krugman's main academic interests: international trade and growth and comparative economic performance. In other words, these duds are not just the rantings of Paul Krugman qua journalist - these are the rantings of Paul Krugman qua academic economist.

Another of Herr Doktorprofessor's central academic interests has been currency. So it's appropriate to take at least a preliminary review of his his prediction about the fate of the US dollar:

The crisis won't come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out. But at a certain point we'll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge. What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government's access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

Keeping in mind that Herr Doktorprofessor was careful to locate this prediction several years in the future, it is still valuable to observe the recent movement of the dollar to see he is correct when he writes that during that period of years America will still be able to borrow freely, simply because lenders assume that things will somehow work out. After all, his prediction of a plunge at the end of that period depends on his prediction that lenders will make their adjustments more or less massively after ignoring the warnings in the mean time. Is that right? Failure of the market to absorb and reflect information - such as currency warnings - is something one more easily associates with small, illiquid instruments - like an under-covered stock or the currency of some minor trading nation. The US dollar is anything but that. So if what Herr Doktorprofessor is predicting is right - and he is essentially extrapolating from his third-world currency experience to say that the US dollar will act a lot like, say, Thai currency did in the Asian financial crisis - that could be another breathtaking, revolutionary revision of classical thinking!

But the US dollar has been in a long-term, gradual decline against the Euro and the Yen. That indicates that foreign lenders are doing anything but assuming that things will somehow work out. In fact, lenders and the world currency markets are digesting the very trade and budget deficit information that Herr Doktorprofessor predicted they would ignore - and those same lenders are imposing gradually rising costs on the ability of the United States to borrow and issue its own currency. That may or may not signal a long-term decline of the United States or its dollar (for example, the dollar declined by about 30% at one point under Reagan), but it certainly doesn't seem very consistent with some future Wile E. Coyote moment that Herr Doktorprofessor so confidently predicted in which the markets' long-overdue understanding of issues long understood by Herr Doktorprofessor comes rushing in.

The Economist reports: Mr Krugman's work on currency crises and international trade is widely admired by other economists. If that's true, perhaps it says more about the current state of the economics profession than about the sterling quality of Paul Krugman's central academic work.