Sunday, September 30, 2007

Finally A Forecaster That Is Being Honest - He Does Not Know What Will Happen.

In an article from Yahoo, Nick Bloom at Stanford University has done some research that indicates that the US economy is potentially in for a "second moment shock" resulting from the credit crunch in August. However, based on historical analysis it is difficult to forecast what the effect will be, other than the level of uncertainty in the economy will be higher.

These comments are interesting becasue finally there is a forecaster that knows that things could get potentially worse, but he is not exactly sure what will happen. Maybe the correct forecast is that the level of uncertainty is going to increase. As a result people can stop wasting there time predicting what will happen (prophecy) and start stating that in their scenario analysis the level of uncertainty is going to increase and adjust their risk, growth, loss, etc. criteria appropriately.

Forecasters are busy churning out new and gloomier economic predictions because of a global credit crunch whose outcome nobody can be sure of until financial conditions normalize and uncertainty subsides.

Investment bank Goldman Sachs joined the swelling ranks of gloom converts this week, slashing its forecasts for growth in the United States, Japan and Europe.

"Much has changed since mid-July, when we wrote that 'the global economy continues to enjoy one of the strongest sustained expansions in modern history'," chief economist Jim O'Neill said in a note announcing hefty forecast cuts.

"The key question, which will take time to answer, is the extent to which the credit crunch will affect the real economy." (my emphasis)

The IMF is working on new and probably lower forecasts after raising its predictions for much of the planet's growth outlook on July 25, a couple of weeks before central banks were forced to take action to try to head off a full-scale credit crunch.

What none of the old forecasts or the new predictions that are coming out now do is factor in the impact of a crisis that has yet to run its course.

Nick Bloom, an economist at Stanford University, has taken a stab at one major facet of the problem, the indirect toll which crises have on business investment, hiring and output because of a sudden rise in uncertainty.

Essentially, this "second moment shock" as he calls it, will have a potentially far greater impact than the crunch itself in the first three to six months of the affair. (my emphasis)

He constructed a model using stock market volatility during more than 40 years since the Cuban missile crisis of late 1962 as a proxy for uncertainty to help identify the impact that the events have on corporate behavior.
"These shocks appear to have real, large effects, with the uncertainty component alone generating a one percent drop and rebound in employment and output over the following six months, with a milder long-run overshoot," Bloom says.

The impact of the underlying shock which in the first place triggered the uncertainty at corporate level -- be it war, oil price spikes, stock market crashes or the currency credit crunch -- can have an impact for a more prolonged period.

"While the second moment effect has its biggest drop by month 3 and has rebounded by about month 6, persistent first moment shocks generate falls in activity lasting several quarters," Bloom says in a research paper.

"There's a short sharp burst of uncertainty. It's a sort of double-whammy," Bloom added in a telephone call with Reuters. (my emphasis)

Central banks can cut interest rates to ease the pain of the current credit squeeze, but monetary policy has a limited impact until anything between nine and 18 months later, he added.

That means the uncertainty shock, something central banks are very wary of but have difficulty quantifying, will hurt hardest between now and the year-end.

"It's kind of half of a recession. The credit crunch gives you the other half, so you basically get a short recession," Bloom said.

Just how uncertain things are for economic forecasters was highlighted recently when the International Monetary Fund raised its forecasts for global economic growth on July 25 to 5.2 from 4.9 percent.

Some two weeks later, the European Central Bank began a wave of emergency lending to prevent money markets form seizing up and the IMF, along with many others, could do little more than say it would soon try to revise the forecasts again.

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