Can Economists Help You Pick a Better Mortgage? — Part I
“Isn't anyone fed up with the genius economists and their behind-the-curve predictions?” – John McCrae
That quote is from a reader responding to Thursday’s article on rate cut speculation. It nicely reflects the pervasive frustration with economists today.
Indeed, it's been a bad year for financial forecasters. (Some would say: “a bad four decades.”) Economists have been changing their rate forecasts more frequently than some people change their kitty litter.
In part I of this two-part story we’ll examine why that is, and look at why economists fail—try as they might.
In part II we’ll evaluate where they come in handy and how their research can help with mortgage term selection.
Frustration with economists isn’t new. Ezra Solomon once said, “The only function of economic forecasting is to make astrology look respectable.” Well, given economists’ dismal track record, you can’t blame mortgagors for wondering if rate forecasts have any relevance whatsoever for mortgage selection.
Before broaching that topic, however, let’s look at why economists make headlines in the first place.
The answer is unsurprising. Economists don’t make the news because they’re omniscient. The media quotes them because people hate uncertainly, and thus, we crave prophesies. People think that maybe, just maybe, economists will get it right this time.
Financial professionals, on the other hand, know that the value of economists has never been in their specific consensus rate forecasts. Economists’ rate calls are right roughly 51-52% of the time (that number varies depending on the study, timeframe and what’s being projected). Interestingly, their forecasts have also been shown to have a rate-increase bias—at least recently. (Source)
Even the Bank of Canada, the nation’s most respected and relied-upon economics body, is regularly forced to revise its forecasts, sometimes substantially.
Since economists are often throwing darts in the dark, they like to travel in packs. Hiding in the consensus ensures they don’t stick out when they blow a call. Unfortunately, the consensus leaves much to be desired. (For a sampling of economists’ uninspiring record, see our January 2008 story Predicting Interest Rates: Futile.)
Forecasting futility occurs for two simple reasons: a) Economies are extraordinarily complex, and b) the world is highly random.
You can’t predict if a roulette ball will land on red or black, and similarly, economists cannot forecast (with confidence) if rates will rise or fall one year from now.
Paul Wilmott, our favourite quant, has said: "Economists' models are just awful.” He characterizes what economists do as: “The jargonizing of complex ideas based upon irrelevant assumptions into an easily used and abused building block on which to build the edifice of nonsense that is modern economics.”
“What you want to do (when modelling the economy)”, he suggests, “is throw away all but the half dozen most important equations and then accept the inevitable, that the results won’t be perfect.”
Some critics assert that economic predictions are just plain meaningless. They point to a thing called “tail risk.” That refers to major unexpected events that can turn any economic forecast on its head. Examples include wars, enormous earthquakes, fiscal or market crises, major tax policy changes, or life-altering inventions like the Internet, low-cost hydrogen fuel cells, batteries that power cars for 1,000 miles, a cure for cancer, etc.
These are the types of events that few can see coming. In turn, if you can’t see them coming, how can you predict rates with accuracy and consistency? The answer, of course, is that you usually cannot.
Thus far, we’ve talked about economists’ failings. In part II this week, we’ll talk about what they do right. Yes, believe it or not, economists are not employed for nothing. We’ll also look at how they occasionally come in useful when selecting a mortgage term.
Sidebar: Speaking of a cure for cancer, the University of Chicago said a while back that “Finding a cure for cancer would be worth about $50 trillion.” That’s about 3.4 times U.S. GDP. To the extent this affects economic consumption, one may assume that interest rates could somehow also be affected by a cure, to at least some degree.