When I started college, I wanted to be in politics. I was already of a Libertarian mindset, and had it in my mind that I could change the world. I picked economics as a major to learn about setting policy, not because I wanted to get into investments. Suffice to say I've fallen from the true faith and am now little more than a money grubbing trader.
Anyway, early in my college career I wrote a paper on budget deficits. Having a Libertarian bias to begin with, I set out to find sources which would conclude that budget deficits were evil. Lawyering? Hey, I wanted to get into politics at the time. Cut me some slack.
Lo and behold, I had no trouble finding academic papers suggesting that the ever growing budget deficit would eventually cause financial Armageddon. I slapped a series of quotes and charts into my own paper, called it research, turned it in and got an A. I became convinced that balancing the budget should be priority #1, and that politicians were tax and spending us straight to disaster.
As I moved further in my studies of economics, I realized that something like the budget deficit was unlikely to have a major impact on the economy in any given year. And as I became more involved in projects involving near-term economic projections, variables like the size of the national debt never worked as predictors. Despite all those sensationalist papers I read at the beginning of my academic career, the large national debt was something more likely to slowly eat away at economic potential, and less likely to cause some sudden economic crisis.
If I wanted to get better at forecasting, I had to forget about what I thought should be done and focus on the effect of what would be done. So while politically I'd really like to see the budget balanced, the reality is that we're going to have a deficit this year. I feel my time is better spent considering whether this matters for near-term economic performance rather than railing against the deficit.
So where am I going with all this? Lately we've had a lot of proposals from various sources to alleviate the sub-prime crisis and related contagion. FHA Secure, Hope Now Alliance, Fed rate cuts, the term-auction facility, etc. Politically, if it were put to a referendum, I'd vote against all of it. Well, maybe not the Hope Now which was really just a coalition of banks. But the rest of it, if I were dictator of the world, I wouldn't do anything. I'd make sure the nation's depositors knew that the FDIC was well funded and deposits were safe. The most I'd consider doing is increasing the FDIC insured limit at a bank. Other than that, I'd be for letting the chips fall where they may.
I'd privatize Fannie Mae and Freddie Mac. I'd figure out some way of phasing this in as to not cause all kinds of liquidity problems, but we'd start moving in that direction today.
Even the Fed cuts. If I were dictator of America, I'd mandate the Fed be given an inflation target and give the job of banking regulation to some other office. If the inflation target indicated lower rates, fine, but otherwise I'd rather see the Fed stay out of the economy.
But guess what? I'm not dictator of America, and it doesn't look like I'm going to be any time soon. So what I want to see happen is irrelevant. So rather than spend a lot of time thinking about the policies I want, I work on what the impact of policies will be. So while I hated the FHA Secure plan, I have to admit that it will prevent some borrowers from going into foreclosure. The housing market will be more stable, perhaps only to a very small extent, with FHA Secure than without it.
Same with the Fed providing liquidity. I try to think about it as if I'm Ben Bernanke. I've read a lot of his academic work, so I have some basis for how he's thinking. I've also read a ton of papers written by other Fed economists. As a group, they believe in monetarism generally with a neo-Keynesian streak. They belive that while inflation is their #1 enemy, liquidity crunches can cause big problems. They believe that providing liquidity when liquidity is dear can increase stability.
Now I might believe that the Fed contributes to instability at times, forcing them to react in the future. This may be exactly what's happening now, with the Fed having to deal with the consequences of keeping rates too low for too long. Here again, though, it doesn't help me make good forecasts to harp on the mistakes the Fed made in 2003-2005. I mean, its an interesting conversation, but entirely irrelevant to projecting what the Fed is going to do in 2008.
So I say put your personal philosophy aside when making forecasts.