Prudence demands economic humility, and setting Washington’s finances on a course that can survive normally fluctuating economic variables.
Hubris, economic forecasting, and the road to ruin
T he next time economists declare that they can project the economy’s performance far into the future, remember that the Federal Reserve recently failed to project even a current-year inflation rate within three percentage points.
Specifically, the Federal Open Market Committee (FOMC) forecasted in December 2020 that inflation (as measured by the PCE, the Fed’s preferred measure) would be 1.8 percent in 2021. The Fed hiked the current-year estimate during the course of 2021, but never above 4.2 percent. PCE inflation ended up at 5.8 percent for the year.
Then, the FOMC repeated the same error. Even as inflation tore through the 2021 economy, the committee merely nudged up its 2022 inflation projection from 1.9 to 2.6 percent. PCE inflation in 2022 may end up even higher than 2021.
And it’s not just the Federal Reserve. The Congressional Budget Office’s 2021 inflation estimate was even lower than that of the Federal Reserve. And the Biden White House was projecting a 2.1 percent (consumer price index) inflation rate as late as May 2021.
My purpose is not to pick on the Federal Reserve, the CBO, or the White House – whose technical experts are competently following established economic procedures. Rather, the issue is that macroeconomics remains a social science that — while still in its infancy — is subject to significant groupthink and overconfidence in its precision, despite a poor record of understanding and projecting the economy’s performance.
Often accused of having “physics envy,” economists develop models whose mathematical complexity offers an air of scientific certainty, even as they fail to accurately capture and project the impossibly complicated reality of our economy. And then policymakers rely on their groupthink-driven certainty to enact policies that cannot survive collision with messy reality. The result is economists, markets, and politicians who are blindsided by market crashes, housing crashes, pandemics, inflation, and rising interest rates.
David Card, a co-recipient of the 2021 Nobel Prize in economics, has criticized economists for the “unbelievable certainty that they know what they are talking about, when the actual reality is they do not really know.” On social media and in columns, celebrity economists such as Paul Krugman offer wildly inaccurate forecasts and predictions with the certainty and condescension of a scientist trying to explain the roundness of our planet to a group of ignorant flat-earthers. Yet economics is not a science, and the economy rarely follows the projected path. We are currently suffering the consequences of economists and markets getting inflation horribly wrong, and we face the potential of a larger calamity from the same actors promising that permanently low interest rates will help Washington afford an unprecedented binge of borrowing and debt.
Often Wrong, Never in Doubt
The classic phrase “often wrong, never in doubt” is only a slight exaggeration to describe the fields of economic forecasting and, more broadly, economic commentary.
History is filled with examples of confident, consensus economic predictions that were shredded by subsequent events. In 1929, legendary Yale economist Irving Fisher confidently told the New York Times that “stock prices have reached what looks like a permanently high plateau” — right before the crash that precipitated the Great Depression. Even after the crash, the president of the Equitable Trust Company declared, “I have no fear of another comparable decline.”
Many economists wrongly predicted that the end of World War II would sink the economy back into another depression because so many people were employed to supply the war. Then, in the 1960s, a new Keynesian economic consensus confidently declared victory over the business cycle, leaving only a Phillips curve of inflation versus unemployment to worry about. In 1970, famed economist Arthur Okun announced, “Recessions are now generally considered to be fundamentally preventable, like airplane crashes and unlike hurricanes.” Over the next twelve years, the economy endured four recessions along with (supposedly impossible) periods of simultaneous high inflation and unemployment.
The hubris continued. In the late 1990s, economists and market experts predicted that the tech-driven economic boom would bring a new era of economic growth and soaring stock markets — until the dot-com bubble burst and the tech-heavy NASDAQ market index fell by 78 percent, initiating a new era of sluggish economic growth.
Just a few years later, both economic forecasters and Wall Street’s finest completely failed to foresee the impending collapse of the housing bubble and its ripple effects on mortgage-backed securities and broader markets, resulting in a historic recession and collapse of Wall Street investment bank balance sheets. In early 2000, Lehman Brothers chief investment strategist Jeffrey Applegate was reportedly telling clients to “throw out everything they had learned in the last 20 to 30 years about how markets and business cycles operate,” and invest on the expectation “that the unprecedented continues to happen.” Before the decade ended, Applegate’s own 161-year-old investment bank — the fourth-largest in the country — filed for the largest bankruptcy in U.S. history due to its overextended investments.
The Consequences of Relying on Rosy Projections
Economists, forecasters, and markets missing the mark is not merely an academic issue — these mistakes often drive policy. For years, critics on the left complained that the Federal Reserve’s overly pessimistic inflation concerns were driving unnecessarily tight monetary policies that in turn cost working families’ jobs and wage gains.
More recently, rosy economic thinking has pushed policy into an overly aggressive direction. The most recent example is the Federal Reserve’s failure to anticipate the full extent of the inflationary consequences from trillions of dollars in monetary and fiscal expansions. This induced the Fed to maintain near-zero interest rates far too long, and even continue expanding its balance sheet until just a few months ago.
On the legislative side, the supreme confidence that inflation could never return induced Congress to shoot a $1.9 trillion bazooka at a $420 billion output gap in the form of the American Rescue Plan (ARP). In fact, the few economists who warned about the bill’s inflationary consequences, such as Lawrence Summers, were mocked and dismissed. Instead, the ARP poured gasoline on the inflationary fire, and helped drive the inflation rate to a 40-year high.
Moving forward, the leading danger of hubristic economic thinking is the assumption that high interest rates have been permanently “defeated” and therefore Washington can afford to substantially increase spending and the national debt at virtually no cost. Indeed, much of the justification for President Biden’s massive Build Back Better plan centered around low interest rates.
This argument made little sense especially given that Washington overwhelmingly relies on short-term borrowing, meaning that even a relatively modest future rise in interest rates would soon absorb nearly the entire existing national debt, and that’s before taking account of the fact that Washington is already projected to borrow $114 trillion over the next three decades just to cover the expanding shortfalls of existing programs such as Social Security and Medicare. The low-interest-rate argument for a massive spending spree rests on the assumption that Washington’s interest rate never again exceeds 3 percent at any point in the future. Such an assumption is absurd — and dangerous, given that every percentage point that interest rates rise would cost Washington $30 trillion over 30 years in higher interest costs, or the equivalent of an additional Defense Department.
And yet, that permanent-low-interest-rate assumption has been the basis for the pro-spending argument, despite economic forecasters having been consistently (and strikingly) wrong about interest rates over the past 50 years. The steep rise in nominal interest rates during the 1970s was largely unanticipated, and yet still often failed to keep pace with inflation. The disinflation of the 1980s and subsequent softening of nominal interest rates was also unanticipated.
For the past three decades, economic forecasters, including the CBO, have repeatedly overestimated future interest rates. Jason Furman and Lawrence Summers write that, over this period, “long-term forecasts . . . entirely missed the large decline in real interest rates.” A 2015 report produced by the White House Council of Economic Advisers adds that “between 1984 and 2012, CBO, private-sector forecasters, and the Administration all systematically overestimated the path of nominal interest rates just two years into the future.” A 2019 report shows that these interest-rate forecasting errors have continued.
After missing the 30-year decline in interest rates, economists and markets overcorrected and declared that rates will remain low seemingly forever. The CBO projects that a $114 trillion surge in government debt over the next three decades will still leave Washington’s interest rate lower than the rate that prevailed as recently as 2008. And many economists criticized that CBO interest-rate projection as too high, projecting that rates will remain below 4 percent seemingly forever. The 30-year Treasury continues to trade at 3.2 percent.
Hoover Institution economist John Cochrane has pointed out that “debt crises are like the Spanish Inquisition, no one expects them to come.” He continued: “If you knew they were coming, they would have already happened. Interest rates in fact have never [been accurately] forecast. [Economic forecasters] didn’t forecast inflation in the 1970s and they didn’t forecast the disinflation in the 1980s. So interest rates didn’t forecast the Greek debt crisis. Interest rates didn’t forecast that Lehman was going to go under.”
But the current leaders of the same economics profession and Wall Street firms that have consistently failed to predict even short-term economic variables for the past half-century, now express supreme, airtight confidence that they can predict the yield on the ten-year Treasury bond in the year 2050 (specifically, that it will be much lower than the rates that prevailed as recently as 2008). Economists claim that they have learned from past forecasting errors, built new and updated economic models, and now can finally predict inflation and interest-rate trends decades in advance.
Such continued overconfidence in the face of repeated failures is both arrogant and foolish. Even the most sophisticated economic models are only as good as the assumptions built in by imperfect economists (which are often just extrapolating the recent past forward). And no set of mathematical equations and causal relationships can accurately predict future innovations, government policies, external economic shocks, or the daily economic behavior of 330 million Americans and 8 billion people on earth. In reality, no one has any idea which interest rates will prevail in five, ten, 30, or 50 years.
Given the comparative certainty of escalating demographic-driven federal budget deficits — which will make budget interest costs extraordinarily sensitive to even small interest-rate changes — it would be reckless to commit to decades of permanent new debt on the hope that the interest rate paid on this debt never again reaches 4 or 5 percent. Such levels would not even represent historical outliers; they are well within the normal range of fluctuations over the past half century. Furthermore, the economists who remain married to their forecasting models have offered no fiscal backup plan if they happen to be wrong about interest rates and the debt soars past 200 percent of the economy within a few decades.
Here’s the humble reality. Economists have not “solved” recessions, inflation, unemployment, or the business cycle. Tail risks — from housing crashes to market crashes, and from pandemics to natural disasters — have long been systemically underestimated. Prudence demands economic humility, and setting Washington’s finances on a course that can survive normally fluctuating economic variables. The role for policy-makers is to practice risk management, and enact modest public policies that can adequately survive recessions, inflation, rising interest rates, and the occasional market crash or tail event. A plan that cannot survive economic instability is no plan at all.
Brian Riedl is a senior fellow at the Manhattan Institute. Some portions of this article are excerpted from his recent report, “How Higher Interest Rates Could Push Washington Toward a Federal Debt Crisis.”