Economists caught off guard

The headline in October 2007 said: "Better times coming in '08." Economists and business leaders gathered at Coastal Carolina University said the housing market would stabilize, new attractions would draw tourists to the Grand Strand, people would shop and the economy would grow by 2.3 percent in the first quarter.

Clearly, things did not work out as planned, and the people who used those forecasts to conduct business - perhaps most notably the state budget office - are having to scramble to adjust. Just last week, the state Board of Economic Advisors again said revenue from sales tax and income tax would be less than previously thought, so lawmakers have to slash a budget that has gone through nonstop cuts since April.

"Pretty much everybody missed it," said Mark Gertler, an economist at New York University and longtime collaborator with Fed Chairman Ben Bernanke.

So what went wrong? How did so many smart people not figure out that the national financial system would be rocked to its core by bad debt?

Looking back, economists say they and their complex models were duped by a combination of unprecedented factors. And now, they're using the lessons of the past year to update and tweak their calculations to try to discern what lies ahead.

A change from the past

Economists do their jobs by looking at what has happened in the past and creating complex models to try to apply previous patterns to the future.

"Typically, statistical models tend to treat the future as if it's going to look a lot like the past," said Don Schunk, a research economist with CCU whose predictions were off. "The problem right now this year is that some of those historical relationships are no longer true."

Bruce Yandle, dean emeritus of the College of Business and Behavioral Science at Clemson University, said there were several surprises - spiking oil prices, for one - that caught economists off guard and the typical ways of measuring economic health could not diagnose the problem ahead. He compared it to a doctor who tells a patient his heartbeat is strong, based on national averages.

"Now, you may have a stroke that night, and there's no way for the doctor to detect that," he said.

Another surprise: Consumer spending has fallen more sharply than historical data would suggest, as people started to give up hope that gas prices would ever come down, looked at the housing market and decided this was not the time for splurging.

"We tend to be good at data," Schunk said. "It's a lot of these pieces that have to do with the psychology of households and financial market participants that are very hard to pick up on."

Financial markets have become more complex than the models used to study them, as bankers invented new, unregulated investment products with fancy names like credit default swap, which is debt insurance on loans and mortgages, economists said.

The models were not set up to take into account that large investment banks would take on such enormous, unprecedented risks - essentially lending money without having the reserves to back it up, leaving regulators out of the loop.

"We had a regulatory system that was just totally out of whack with respect to the financial system," Gertler said. "And we had financial institutions that were behaving pretty much like banks that weren't regulated like commercial banks."

Then, at the core of the problem, most economists and investors did not factor in that housing prices would collapse, said Gertler, though he noted there were some exceptions, such as fellow NYU professor Nouriel Roubini, who was nicknamed "Dr. Doom" for his prophecies.

A major reason the country is in the situation it is in, Schunk said, is that there weren't enough economists, like himself, "pointing out that we were setting ourselves up for a big problem."

"It's hard to step in and say our economy is doing well right now, but we need to be really concerned because it's artificially doing well," he said. "Most people are going to get caught up in an economy that's growing. You set aside some of those concerns you might have."

State impact

The impact of the economists' work is widespread. Small-business owners look to the predictions to decide how many workers they should hire, how much inventory to stock or whether to expand. On a larger scale, the Federal Reserve uses economic forecasts to guide monetary policy, such as whether to raise or lower interest rates.

At the state level, South Carolina is now facing a half-billion dollar budget deficit, and lawmakers, after finalizing a budget and then cutting it several times now have to go back and work more political magic.

"It takes months for the legislature and finance to go back and forth on what we're going to cut and what we're not going to cut," said Sen. Ray Cleary, R-Murrells Inlet. "Now it's all up in the air."

That means department heads, such as Chad Prosser with the Department of Parks, Recreation and Tourism, have to spend less time doing the departmental work and more time reworking budgets.

"This is certainly when the job is more difficult," he said last week after an afternoon spent pouring over the budget.

Making the adjustments

Now, economists are going to go back and find a way to work the current predicament into their modeling. Schunk, who said he believes the country is in a recession even though it is not showing up in the typical way - a decline in the gross domestic product - said he needs to analyze what happened and when.

A sudden shock to the system, such as oil prices doubling, leaves economists scrambling to revise, revise, revise.

"One of the sources of error, what turns out to be error, is that the ground you thought you would be walking on has shifted," said Bruce Yandle, dean emeritus of the College of Business and Behavioral Science at Clemson University. "Then the burden is on the economist to talk about what's shifted, what caused the forecast to change."

Schunk cautioned that a forecast, by its nature, will be imperfect at best, an ever-evolving best guess.

"Recognize that if someone gives you an economic forecast in October, that forecast is going to change in November and in December," he said. "It's a real learning process."