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Why you should ignore economic forecasts

(MoneyWatch) Many gurus rely on economic forecasts when telling you where the market is going. However, these forecasts (much like the market predictions) are really nothing more than guesses.

Jan Hatzius, the chief economist of Goldman Sachs, was pretty blunt when talking about the value of economic forecasts: "Nobody has a clue. It's hugely difficult to forecast the business cycle. Understanding an organism as complex as the economy is very hard." Keep in mind that the government produces 45,000 economic indicators each year and private data providers produce about 4 million. The following examples demonstrate the point:

  • The majority of economists didn't "predict" the three most recent recessions (1990, 2001 and 2007) even after they had begun.
  • In November 2007, economists in the Philadelphia Federal Reserve's Survey of Professional Forecasters called for growth of 2.4 percent for 2008, with only a 3 percent chance of a recession, and only a 1 in 500 chance of the GDP falling by more than 2 percent. GDP actually fell 3.3 percent.
  • Since 1990, economists have forecasted only two of the 60 recessions that occurred around the world a year in advance.

As Hatzius noted, the task facing economists is huge. First, it's hard to determine cause and effect from statistics alone. Second, the economy is always changing. Explanations for a particular business cycle may not provide any information about the next one. Third, the data they have to work with isn't very good. For example, the initial estimate of GDP growth in the fourth quarter of 2008 was -3.8 percent. It turned out to be almost -9 percent. Between 1965 and 2009, the average revision was 1.7 percent. As Nate Silver, author of "The Signal and the Noise" put it: "It's hard enough to know where the economy is going. But it's much, much harder if you don't know where it is to begin with."

Compounding the problem of predictions is that you not only have to get the direction right, but also anticipate any government or market responses. For example, if the economy starts to go into a recession, you have to forecast the actions governments and central banks will take to address the problem, as well as the effectiveness of those actions. And since the economies of the world have become more integrated, you have to also get the forecasts right for the rest of the world.

The complexity of the problem is immense. Yet, investors expect precise forecasts, such as being told the economy will grow 2.4 percent in the next year. If they're instead told that the economist is 90 percent sure the economy will grow between 1 percent and 4 percent, they won't trust the prediction. Accuracy isn't important to investors. Confident talking heads is what they seek. Investors want a clear crystal ball. They want to believe that there's someone out there who can protect them from bad things. Unfortunately, no such person exists.

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