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Reading economics research is a bit like watching Charlie Brown attempt to kick the football.
Like the cartoon character, economists have a tendency to whiff when it matters most. Six years ago, they missed the growing dangers in the global financial system and failed to foresee the crisis that has dogged the world ever since. And yet today many of the same people encourage us to believe that a soft landing for the Canadian economy is all but guaranteed. This time, Lucy will hold the football the whole way through. Don't worry.
Investors should be wary of the official pronouncements that all is well. And they should understand the shaky foundations of much leading-edge economic thought.
The main culprit for economists' abject failure to see the financial crisis coming was a modelling technique called DSGE – Dynamic Stochastic General Equilibrium – which gained favour in the early 2000s. Beginning with simple assumptions about corporate and human behaviour, DSGE models built enormously complex scenarios for how the economy functioned – except that the models failed to include financial leverage.
In hindsight, this was more than a minor oversight. If central banks and governments had not come to the rescue, a handful of investment banks would have blown up the global economy.
Narayana Kocherlakota, president of the Minneapolis Federal Reserve, cites the failure of economic models to account for the banking system as the major reason that "during the last financial crisis, macro-economists failed the country, and indeed the world."
Inherent in the DSGE model was a near-Soviet disregard for human psychology. It was assumed, for instance, that banks would never increase their loan books to a scale that would threaten their own solvency, even if bankers could earn gigantic bonuses handing out mortgages to whoever showed up at the office with a pulse.
No sensible person would predict a 2008-style meltdown for the Canadian financial system. But some of the most worrisome U.S. trends in the lead-up to 2008 are now apparent in Canada.
Observers ranging from the International Monetary Fund to Bank of Canada Governor Mark Carney have frequently pointed to the explosion of household debt. South of the border, consumer debt as a percentage of disposable income peaked at 130 per cent in the run-up to the crisis. Canadian household debt now stands at 166 per cent.
And how about our vulnerable housing market? Economists at many of the major banks counter claims of a bubble by noting that low rates make larger mortgages more affordable. This is true – just as it was for Americans before 2008. But according to Royal Bank of Canada, the average price of a two-storey Canadian home has climbed to seven times household income from four times in 2000. What happens if, as many economists believe, China's economy slows and profits from Canada's resource-related industries take a nosedive? Or if mortgage rates climb?
As readers of economic research, we have to operate on blind faith – and it would help if economic forecasts had proven reliable before the financial crisis. For Canadians, it would also be preferable if many of the country's most prominent economic minds were not employed by the financial institutions that hold the vast majority of mortgage liability.
Many academic economists continue to squabble about mathematical details without ever reaching consensus. In contrast, the rare economists who did predict the U.S. housing bubble used logic that could have been understood by a fourth grader.
Yale professor Robert Shiller and Dean Baker at the Center for Economic and Policy Research argued simply that housing prices have a strong historical tendency to track inflation. (Mr. Baker added income growth as a variable.) Once home prices surged ahead of CPI, a reckoning was sure to follow.
The lesson here is that ivory tower economics is frequently too complicated for its own good. Canadians would be better off with more homespun wisdom. Record debt levels will lead to record debt de-leveraging no matter what the economists say.
Scott Barlow