August 9

Flexible Forecasting: Looking for the Next Economic Model. Bill Watkins, newgeography.

The world changed in September 2008. We call it a regime shift. It's a move from one (good) equilibrium to another (bad) equilibrium. Statistical models that worked well in the old regime don’t work in the new regime...

Some economists didn’t recognize the regime shift. They went about their business using the same old models in a new world. Comments about the length of a typical recession or about how sharp declines are followed by rapid recoveries were clear signals that the speaker didn’t understand the situation.

Some economists were fooled by the stimulus. The rules of accounting cause government spending to be reflected as an increase in economic activity. Stimulus plans such as Cash for Clunkers and tax credits for home purchases moved the timing of transactions, artificially reinforcing the direct spending impacts. Similarly, bailouts and foreclosure prevention programs postponed the recognition of losses.

Many interpreted the resulting increase in last winter’s reported activity as permanent, but that could not be. We were not building anything or laying the groundwork for sustained prosperity. Instead, we were just continuing the previous decade’s consumption binge. The banks had failed, but the government had stepped in. It became the mother of all banks, borrowing from future citizens and other countries to fuel today’s consumption.

I happen to think the world changed earlier than September 2008: perhaps the summer of 2007, when the music stopped playing and the credit crunch began; perhaps earlier, when U.S. housing prices began declining; in any case, it certainly pre-dated LEH.

I'd also say that rather than "some economists didn't recognize the regime shift" it would be more accurate to say: the vast majority did not --- in fact, most still do not.

To follow up on Watkins' point that:

"The stimulus’s omissions are glaring. We didn’t significantly invest in infrastructure that would improve our future growth. We failed to address the weaknesses in our education sector that fuel increasing inequality, sentence many to a life of hopelessness, and permanently constrain our economic growth. We did nothing to encourage small business’s growth"

Paul Krugman, in America goes dark (NYT), says that not only was the opportunity lost to use fiscal stimulus to improve infrastructure and education, but the country is now moving backwards on those fronts:

And what about the economy’s future? Everything we know about economic growth says that a well-educated population and high-quality infrastructure are crucial. Emerging nations are making huge efforts to upgrade their roads, their ports and their schools. Yet in America we’re going backward.

Waiting for nothing? Tim Duy, Fed Watch.

Word on the street is that Fed staff are increasingly frustrated with the lack of action from leadership. Why exactly is Bernanke showing such deference to the more hawkish elements such as Kansas City Federal Reserve President Thomas Hoenig, Dallas Federal Reserve President Richard Fischer, and Philadelphia Fed President Charles Plosser? If you seek more easing, you are not alone. Board staff are increasingly your allies.