Talk of recession in the United States has gotten louder recently. Last summer Alan Greenspan saw a 30 percent chance. Now he describes a greater than 50 percent probability. An Associated Press article last week quoted one Wall Street economist with the same 50 percent number, while another at a competing firm listed a 40 percent chance.
The economists who venture these opinions may be knowledgeable and experienced. They probably will be proven right in their forecast of tougher economic times ahead. But any such predictions should be approached with a healthy degree of skepticism, for the probabilities are fundamentally different from others one may encounter. These predictions are highly subjective and not based on any statistical inference.
The difference is a variation of what Donald Rumsfeld called “the known unknowns and the unknown unknowns.” Insurable events are “known unknowns.” I don’t know if I am going to have a heart attack tomorrow or get hit by a bus. But there is detailed data on the incidence of sickness, injury and death for 57-year-old males in the United States.
Many insurance companies are willing to write me a life policy based on that actuarial data. The same is true for the probability of glass breakage on my car, hail damage on our farm or the likelihood that the temperature on any randomly chosen day in February will be above freezing.
For all of these questions, there are thousands or millions of data points from which to draw statistical inferences.
The same is not true for the collapse of asset price bubbles or the onset of recessions. These truly are “unknown unknowns.” Yes, these are not new in history. But they are so limited in number and so complex in how they occurred that there is no basis for making statistically valid inferences about prospects for 2008.
Indeed, bursting financial bubbles and recessions probably are not events that are part of a “normally distributed population.” They don’t represent points on a bell-shaped curve. Information about how events will unfold is not only unknown, but unknowable.
Economists do compare historical cases and try to tease out common patterns. One recent study compared 18 different prior cases in the U.S. and other industrialized countries. It found similar patterns of rising housing and stock prices, rapid increases in indebtedness, inflows of foreign capital, and so forth. Its authors calculated the average ensuing drop in asset prices and depth and duration of recession. But these averages are highly influenced by just a few cases. Take out the 1929 crash and Japan’s post-1989 struggles and the numbers change a great deal.
When following the economy, understand that most predictions about 2008 are educated guesses. Even if made by intelligent, experienced individuals, they remain highly subjective. Events could play out in myriad ways.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.