Thursday, July 9, 2009

ECRI's reply to my post

I am delighted and honored that Lakshan Achuthan, the Managing Director of ECRI, was kind enough to respond to my earlier post on ECRI. He has allowed me to post his comments (in blue) and my reply to his comments appear in red.

I don't have too much respect for the field of economics. There are many brilliant economists but, as a whole, I think that they rely too much on modelling and theory.

FYI, ECRI’s work is not based on econometric models.

There are a few great ones (David Rosenberg, for example). Others that I sometimes disagree with (Paul McCulley and Paul Krugman) must be read as they are brilliant thinkers. Even Alan Greenspan and Ben Bernanke are intelligent, although they have made many grave errors.

Until late 2007/early 2008, I had thought that ECRI (Economic Cycle Research Institute) was a star and I assumed that whenever the recession hit, they would be leading the call.


I believe that they are one of the few (or only?) major organization that correctly called the 1991 and 2001 recessions, without any false alarms. In addition, ECRI had a legend, Geoffrey H. Moore, as its founder. Click here for more details on Moore and ECRI.

In September 2000, ECRI warned of a possible recession while most (including yours truly, sadly) thought that the tech boom would last another decade. In March 2001, ECRI called a recession at some point in 2001 inevitable. Later it was determined by NBER (National Bureau of Economic Research) that a recession started that month (March 2001). Never mind that they gave no definitive advance warning of that recession (they stated some point in 2001 when in fact, the recession started that month). At least they were on the right side of the fence.

The 2001 call was borderline, in that it did not advance notice as they are supposed to predict cyclical turns.

I am reminded of what Geoffrey Moore once told us, viz., that if you could predict a recession just when it was starting, you were doing very well as a forecaster. By those standards, I think we did very well in predicting the 2001 recession. In fact, it is practically impossible to consistently predict recessions many months in advance in real time unless you are willing to issue a fair number of false alarms.

Also, if I may, I’d like to cite the precise wording we used in our September 2000 warning of recession danger to our subscribers: “Never in this expansion have the leading indicators been so close to forecasting a recession.” That’s more than a warning of a “possible” recession, wouldn’t you say?

Yet we also went on to write that “Luckily, underlying inflationary pressures have already turned down,” meaning that the Fed had room to cut rates right away, in September 2000. As we now know, the Fed waited four long months before staring its rate cut cycle, and by March 2001 our leading indexes were down so far that a recession was unavoidable. At the time, 95% of economists surveyed by The Economist magazine thought that there would be no recession, so if our March 2001 call about the inevitability of recession was “marginal,” we’re happy to take that, thank you!

This brings home another important point, which is that recessions are rarely as unavoidable in real time as they appear in retrospect. It is quite possible that if the Fed had slashed rates starting in September 2000 we wouldn’t have had the 2001 recession, despite the dot-com bust. As I discuss later, this was also true of the current recession.

For 2001: I take it back; You are correct, and I think that Mr. Moore was probably correct, in that there would be some false alarms.

However, I disagree with the whole Fed causing and preventing recession thing because that is part of the problem that got us here: The Fed as some type of godlike group that can manage the business cycle. As capitalists, we ridicule central planning and communism, yet we believe that some economists can manage the business cycle better than the market? That false belief by investors and government was part of the reason that we had so many bubbles in the past 15 years. The Fed does deserve some blame but this was a global phenomenon. I subscribe more to the Austrian school on this stuff. One need only to look at the fine work a private sector organization like yours performs, versus the shoddy leading indicators that currently come from the government. The Fed has some control over short term rates but often the market leads the Fed. In the above example, short term rates set by the market had already started dropping well ahead of the first Fed cut in January 2001. And even if you are right, and the Fed could have prevented the 2001 recession, I believe that recessions are necessary to clean up the excesses of the past boom, and preventing them leads to an even larger recession eventually. The shallowness of the 1991 & 2001 recessions and the quick fixes via stimulus/deficit spending/this false belief probably worsened the current recession. We had a great worldwide boom from 1992-2007, some of which was based on excess credit and inflated assets. I think it is to be expected that a great bust should follow.

I am willing to concede that this is probably conjecture.

The current recession was determined to have begun in December 2007 by NBER. In December 2007 (from ECRI's site):

"With Weekly Leading Index growth not far from its lowest reading since the 2001 recession, U.S. growth prospects have clearly darkened, but a recession is still not inevitable," said Lakshman Achuthan, managing director at ECRI.

OK, fine, let's assume that ECRI did not agree with NBER that the recession started in December 2007.

Not at all – we agree with the NBER that the recession began in December 2007. In fact, knowing that this was precisely what was likely if emergency action wasn’t taken, we wrote ( in January 2008 that “a self-reinforcing downturn has already begun (italics mine). If allowed to continue, it will amount to the vicious cycle known as a business cycle recession.”

OK, at least there was warning of a downturn. I would have preferred a clearer call but at least, the self-reinforcing downturn was called.

In late March 2008, they gave the official call:

The U.S. economy is now on a recession track. Yet this is a recession that could have been averted.

I think it is clear, as it was then, was that this was not a recession that could have been averted. No amount of stimulus in late 2007 would have saved Lehman, Bear Stearns, AIG, nor would it have saved the US consumer , nor would it have prevented the US housing bubble from blowing up. No amount of stimulus would have saved the commodity bubble, nor would it have saved the record high profit margins of US corporations. This "averted" is simply a way of deflecting blame on a missed call.

The Weekly Leading Index turned down in early June 2007 in real time, six months before the recession began (please recall that in both the second and third quarters of 2007, GDP – a coincident measure -- grew at almost a 5% pace, matching a four-year high, confounding many prematurely pessimistic economists).

But our January 2008 note also explained why we believed at the time, and still firmly believe, that there was a highly unusual opportunity for immediate fiscal stimulus to push back the recession – with very different potential consequences, we believe, for Lehman et al, because resolving the credit crisis outside an ongoing recession is very different from trying to do so in the context of recessionary job losses driving up foreclosures and thus multiplying the “toxic” assets at the root of the crisis.

Of course, fiscal policy action in early 2008 would not have prevented the US housing bubble from blowing up – but the major top in home prices was in late 2005, two years before the recession began, meaning that the home price downturn was not joined at the hip with recession.

This recalls the larger point, that while business cycles cannot be abolished, recessions are rarely as inevitable as they are made out to be in retrospect. Many now blame the recession on the lax monetary policy of 2002-03. We don’t disagree, but once the Fed had made that mistake, are you saying there was nothing anyone could have done in the next five years to avert the current recession?

See above point- depressions happen usually once in a lifetime (assuming that this is a depression) partly since no one expects one since they never experienced it firsthand.

Perhaps Lehman et al would have bought some more time, but again, it depends on which side of the ideological fence you sit on. Lehman, AIG, Bear, Citigroup etc.. basically were insolvent and in some cases committed fraud via off balance sheet, no different than Enron. There is no free lunch. If they were illiquid, fine, stimulus may have helped buy time for them to raise capital. They were insolvent and overly leveraged.

A little late in my opinion, for an organization that is supposed to predict recessions, not call them in real-time time, or after the fact.

This is Strike #1 (i.e. no real advance warning again and quite possibly late by 4 months if you believe NBER, as I do).

Our March 2008 recession call was three months after the recession began in December 2007, right? But as we’ve already noted, we knew at the time, and wrote explicitly in January, that if emergency policy action was not taken, a recession would be judged in retrospect to have already begun before January.

Fair enough- thank you for the clarification

In fairness to ECRI, their leading indexes did deteriorate by December 2007, but perhaps not early enough or far enough to issue a call. Their leading indexes also did deteriorate in the fall of 2008 to multi-decade lows.

Strike #2:

The Economic Cycle Research Institute's Leading Home Price Index is "pointing to a bottom in home prices" and signaling a recovery in demand, said Lakshman Achuthan, ECRI's managing director.

This was written on May 2007 (on the ECRI site). Oops. Housing prices only really began to plummet after this call.

Actually, the data on both median new and existing home prices show that there really was a short-lived home price upturn from September 2006 to March 2007 that was correctly anticipated by the Leading Home Price Index (LHPI). But the LHPI then turned down after peaking in February 2007. The data available at the time I made that statement did not yet show enough of a downturn to indicate that a new cyclical downturn in the LHPI had indeed begun.

This I take issue with. If I was relying on your index to buy a home in 2007, I would be possibly in deep trouble. I acknowledge the short-lived upturn, but I think unlike the calls above, this one has to be judged, with 20/20 hindsight, to be dead wrong. Housing prices are down enormously since then. Also, I read your book and when a similar call that housing would hold up and even prosper in the 2001 recession (100% correct), you touted this call. If this call had been correct and housing did bottom, I suspect that you would tout this call as well. This is not correct, IMHO.

Strike 3?

Now, ECRI is saying the following (and to their credit, said this back in late April, before the consensus embraced this view):

"We'll definitely see the end of this recession this summer," ECRI managing director Lakshman Achuthan said Wednesday. "As unique and unprecedented as this recession has been, the transition to recovery is showing up in a textbook way in the leading indicator charts."

Achuthan acknowledged that difficulties such as unemployment and excess debt will take a long time to overcome, and that confidence is weak. That's to be expected.

"The general mood is probably overly pessimistic. That's quite normal in the wake of a crisis. There is almost always a giant error of pessimism," he said.

I suspect that their models work better with garden variety recessions, not credit and housing bubble induced depressions. If they blow this call, I think that this will be strike #3 in my book. I suspect we will learn the truth in the next few months, and if I am wrong, I will issue a full apology to ECRI for my criticism on this blog.

Our leading indexes should work not only with garden-variety recessions but also with jungle-variety panics, depressions and crises – because uniquely, ECRI’s indicator systems were originally built on that basis, and we have leading index data going back well over a century. Our leading indexes are even more emphatic now about a near-term end to the recession than they were in April, but we’ll have to wait for the dust to settle over the next few months before we know whether we were right to make the call.

On this, I agree, only time will tell.

While I think ECRI is wrong, I will admit that they are the only thing going for the bull camp in my book.

I wanted to add, that this exercise illustrates how great an organization ECRI is, in that it provides gutsy calls and more often than not, have been either 100% correct or way ahead of the 95% of economists cited above. I have picked on bank economists and central bankers as being way behind the curve and would never bother analyzing their calls to this degree since I would have to write a novel.

Perhaps ECRI has only 1 strike in my book (the housing bottom call) thus far. At least, their call to an end of the reession is backed by much more than the talking heads on CNBC. Time will tell if they are right on their end to the recession call.

Thank you so much, Lakshman, for taking the time to reply to my little blog and for your excellent work over the years. With clarification, some of my criticisms may have been a little too harsh, while I still stand by others. Nonetheless, I will always remain interested and read the work of ECRI.


BBC said...

I still don't think that the recession will end this summer but as you say, 'time will tell'.

This is a great article and I WISH the 'News' had half as much integrity as your blog!!!!

Thanks again,
#3 ;)

Anonymous said...

What's your opinion on this article?

Adil Burney said...

good to see these issues being covered by non business magazines since these issues impact everyone. I'm not a complete conspiracy guy but it should be obvious to everyone that GS and its former employees have a huge influence on the world, and the article is a good one.