Greenspan is no hero

By C.W. Mayer

"Is there a government apart from the people? Is there any foresight apart from humanity? . . . nothing is more senseless than to base so many expectations on the state, to assume the existence of collective wisdom and foresight after taking for granted the existence of individual imbecility and improvidence."
-- Frederic Bastiat.

"To my mind the Fed is a cross between the late unlamented Interstate Commerce Commission and the Wizard of Oz. It is a Progressive Era regulatory body that, uniquely among the institutions of that era, still stands with its aura and prestige in tact. It is a remarkable thing that people believe the Fed can do just about anything, up to and including the prevention of tooth decay."
-- James Grant.

The economy has been good for most of us in the past several years. People are often trying to explain the success. There are those who give Greenspan a good bit of credit and say things like "he has done a good job managing the economy". Apart from the inherent absurdity of anyone "managing" an economy, these people have misplaced their faith. I am often amazed at how much faith people place in the power of the Federal Reserve, Greenspan in particular, to stem recessions and global crises. Have people forgotten that the Fed is made up of fallible human beings that are not omniscient. Why do they feel anyone can possibly manage something as complicated as the economy?

Look behind the awesome display of apparent wisdom and power of the Fed. Behind this façade, there are simply more bureaucrats pretending to manage something that they cannot possibly manage effectively. I believe that the illusive powers of the Fed can more accurately be portrayed with the metaphor chosen by economists J.W. Henry Watson and Ida Walters. That is, the Fed has a toy steering wheel that gives the illusion of control, but, the steering wheel is not connected to the driveshaft.

To presume that Greenspan (or the Federal Reserve or the central bank of any country) can regulate an economy and provide a smoother path of expansion rests on several fantastic notions: First, you must believe that through the manipulation of one interest rate, the whole economy responds in some predictable fashion. Second, believing in the first fantastic notion, you must believe that Greenspan knows where this rate should be set. Third, if you accept the notion that Greenspan knows what rate should be set, then you must believe that Greenspan can foresee how the economy will react to such changes in monetary policy. Essentially, you must believe that he knows the future.

Let's attack this at the core. Does Greenspan know the future? Will all the computers and models in the land improve the ability of Greenspan to forecast the future? Of course not, Greenspan puts his pants on one leg at a time. In other words, he is mortal, error-prone, imperfect and just like us. David Dreman's latest book, Contrarian Investment Strategies, contains some interesting research on the issue of forecasting. Dreman deals with the ability of security analysts to predict, collectively and accurately, a company's future earnings.

Keep in mind that these security analysts are among the brightest people in their profession. They are often from the world's best schools and are paid handsome sums for their work, sometimes in excess of two million dollars annually. These analysts are experts in their fields. They have access to an incredible wealth of information. All kinds of trade magazines, newspapers and specialty reports cross their desks. Not only that, they have access to the people at the companies they follow. Analysts have access to the Chief Financial Officer and Chief Executive Officer. They can ask them specific questions about their forecasts, about industry conditions. These analysts have the latest and best computer technology, complicated models to aid them in their analysis. Their incentive compensation is often tied to the accuracy of their forecasts.

So, how accurate are their forecasts on earnings? Abysmal. David Dreman and Michael Berry performed a study on analysts' forecasts between 1973 and 1996. It examined quarterly forecasts of earnings with actual earnings for the period. Forecasts were usually made a couple of months in advance, but analysts could revise their forecast up to two weeks before the end of the quarter. In all, Dreman and Berry used 94,251 consensus forecasts. At least four forecasts had to be made for a stock to be considered in the study. For larger companies such as Exxon or Microsoft, here may be thirty or forty estimates. More than 1,500 companies were included in this comprehensive study.

The final results: the average error in the sample was 44 per cent. Even after taking out small earnings of plus or minus ten cents (to correct for possible distortions from these smaller estimates), the average error was still 23 per cent. This means that, on average, an earnings estimate of $1.00 was in error by 23 cents. This is a large error. Dreman reconfigures his study in numerous ways to further test his conclusions. Did analysts do better in bull markets versus recessions? Was accuracy better in more "predictable" industries like utility companies? We won't go through the all the results here. Interested readers are encouraged to purchase the book, which is much more than an investment book. Suffice to say that in every case, and in every way, the errors were large, sometimes exceeding 50 per cent.

So if the best financial analysts cannot predict a company's earnings with any reasonable accuracy, even after allowing them to adjust their forecast within two weeks of a quarter's end, how in the world can Greenspan know what the economy is doing? The economy, being made of thousands of companies, millions of people, is many times more complicated than one company's earnings forecast. And, unfortunately, Greenspan can't go interview the economy.

Let's look at it another way. Have governments past or present been able to accurately set the price of any good? Of course not. All these attempts have ended in chronic shortages or wasted surpluses. This is why we have markets to discover these things. Prices are nothing if not set by free buyers and sellers interacting in the market economy. So why do we allow a set of bureaucrats to attempt to set an interest rate? Why do believe they can know the direction of an economy? People believe it because it gives them comfort to know someone is in control. People are unwilling to accept that economic forces are beyond the control of governments and do not appreciate the real difficulty in forecasting the future. Through intervention, a government can only become a source of instability, as it misses the mark that would have been set by market forces. This is the essence of the Austrian theory of the trade cycle, that thecentral bank causes booms and busts.

It important to note that the extent of the distortions caused by the intervention is never obvious. We won't know how much of a fed-induced boom this has been until way after the fact. Again, the Austrian theory provides a good framework for understanding how the Fed becomes a source of instability. There are many excellent books covering the Austrian theory of the trade cycle. Visit the von Mises organisation to review these titles.

In conclusion, Greenspan is no hero. It may more accurately be said that the U.S. economy has managed to flourish despite Greenspan's stumbling in the dark, rather than because of him.

This piece is reprinted with the kind permission of The New Australian.




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