"Kee" Points with Jim Kee, Ph.D.

Most of the macro data last week was positive – strong U.S. manufacturing Purchasing Manager’s Index (PMI), positive preliminary PMIs in China and Europe, and positive construction spending in the U.K. In fact, the U.S. PMI increased from 56.2 in September to 56.4 in October (anything over 50 indicates expansion), the highest level since April of 2011. Most experts expected a decline in October due to the two week partial government shutdown. Just another reminder (as if one were needed!) that economic forecasting is as much art as science.

 

And that subject is worth a few words. Most laymen think of economics as predominantly a forecasting discipline when it is really more of a science of trade-offs. “Economists sometimes let themselves be defined by the public’s fascination with soothsaying,” argues economist Deidre McCloskey, but in fact “forecasting and other magic fails…I would argue that economics itself says this.” How so? Well, economist Robert Lucas explained in his memoirs a Eureka moment when, in 1961, he attended a lecture in which the professor (Jack DeMuth) asserted that, “If your theory reveals profitable opportunities, you have the wrong theory.” Lucas went on to win the Nobel Prize in economics based upon his work on rational expectations that basically elaborated upon that statement. And yet, the ability to forecast implies profitable opportunities everywhere…in markets for corn, wheat, interest rate futures, stocks, real estate, etc. What Lucas and McCloskey are saying is that if you could forecast the future by working through, say, an economics or econometrics textbook, everyone would do it and be rich. But economists by and large earn their living selling forecasts, not acting on them!

 

Back to the global data, it points to moderate expansion (3% growth), not a boom (5%+ growth) like the anomalous 2002-07 period. In my presentations I often cite Robert Mundell’s assertion that the greatest risk to fiscal insolvency in Europe is a Euro that is too strong. Mundell argued that the European Central Bank and the U.S. Federal Reserve should keep the Euro from rising too far above $1.35 per Euro or falling too far below $1.25 per Euro. Last week the Euro exceeded $1.35, and that’s why you see a lot of calls for the European Central Bank to cut interest rates and pursue other policies consistent with “loosening” on the monetary policy side of the equation. Particularly since Euro area inflation unexpectedly slowed to 0.7%, well below the ECB target of 2%. Part of the Euro’s strength has to do with money flowing into European assets as global risks have declined (e.g. no tapering in September by the Fed, lower tensions in Syria, smooth German elections, end of U.S. government shutdown, etc.).