Mr. Bean Strikes Again - More candor from a central banker

The infamous Mr. Bean (no, not that Mr. Bean) has struck again.  Mr. Charles Bean, Deputy Governor for Monetary Policy at the Bank of England, already famous for his commentary about getting seniors to spend their savings, gave a speech last week to the Royal Statistical Society Statistics User Forum Conference where he discussed the "swing and miss" when it came to the Bank of England's predictions about the Great Recession of 2008 - 2009 (or what he refers to as the "Great Contraction").

Here are a few comments from this most illuminating speech where he discusses the use of statistics in the study and control of the business cycle:

"...First, and most obviously, there is the wealth of official statistics on the economy generated by the Office for National Statistics (ONS) and other national statistical agencies, covering such variables as output, employment, pay and prices. That is the absolute bedrock on which our analysis and policy rests, and without it we would struggle to do our job.

But the picture they provide is rarely perfect.  Series often do not quite correspond to the appropriate economic concept, either because they are conceptually difficult to measure or else because only imperfect proxies are available.  As an example, take output.  In the old days, when the economy was dominated by manufacturing, it might have been relatively easy to measure the volume of output and value added of different industries.  But our economy today is dominated by services.  Conceptually even defining the value added in, say, the financial sector, let alone measuring it, is not straightforward.  Moreover, the meaning of a series often changes subtly over time as the economy evolves.  Manufacturing today is a very different animal from manufacturing 30 years ago: for instance, the value added of Rolls-Royce aero engines today comes as much from the after-sales and maintenance as from the engine assembly itself..."

Basically, the Bank of England has a massive pile of numbers that, while they are the bedrock of their policy decisions, are actually quite far from perfect.  Perhaps that explains the following:

"It is worth stressing that we were not alone in thinking a very severe contraction in activity was unlikely.  Almost all forecasters were in the same boat.  For instance, when we prepare our projections each quarter, we also canvass the views of outside forecasting bodies. Their assessment of the probabilities of various ranges of possible outcomes was very similar to ours...

In other words, there's not an original thinker in the bunch.

Mr. Bean continues:

Why then, as the Queen famously asked at the London School of Economics in November 2008, did no-one see the Great Contraction coming? Some economic downturns are broadly predictable in nature. In particular, that is the case when they are deliberately policy-induced in order to squeeze inflation down, though even then it may still be difficult to get the magnitude and timing right, and there will always be other unexpected events that perturb the path of the economy.  But downturns associated with financial or banking crises are rather different animals.  Rapid growth in credit and asset prices can act as a warning sign of building vulnerabilities, (my bold) but frequently appear to be validated by developments in underlying economic fundamentals...

With hindsight, we now know that much of that financial innovation in fact left risk concentrated in the banking sector; it was in effect simply shifting maturity transformation off balance sheet, where it was not subject to the same regulatory requirements.  To that must be added: the underestimation of risk, coupled with inadequate risk management; distorted incentives facing the originators of US sub-prime mortgages and the ratings agencies responsible for assessing complex structured finance assets. Finally, the complexity of those products and the high degree of interconnectedness between financial institutions meant that the financial system, instead of becoming more stable, had in fact become more vulnerable to failure.

The lesson I want to draw from this is not that the problems in financial markets which began in August 2007 and culminated in the near-meltdown of the global financial system a little over a year later were an inherently unpredictable Act of God. (my bold)  Rather it is that one would need to be endowed with perfect foresight to have been able to predict how the financial crisis would unfold, spilling over from one institution to another, and from one market to another. And who knows what would have happened if, for instance, Lehman Brothers had successfully found a buyer that weekend in September 2008?"

From what Mr. Bean is saying, economists including those at the world's central banks ignored the signs of impending doom because they deliberately chose to look past the fact that consumers of real estate in the United States were becoming highly leveraged in housing markets that, to some non-mainstream analysts like Jim Puplava at Financial Sense, warned of an impending housing bubble.  What exactly did central bankers not notice about people buying more than one house, speculating that prices in the real estate market had nowhere to go but up as they had for several years in a row?  What did central bankers miss about the explosive growth in second and third mortgages used to buy new cars, big screen televisions and new computers?  What did central bankers not notice about the mountain of debt and the negative savings rate?  Were central bankers unaware of the massive print and television advertising campaigns that promoted mortgages with teaser rates and low down payments that lured consumers into borrowing money that they could not afford to repay?

Here, in one sentence, is the summary of his argument:

"The moral from this is that one should not expect to be able to predict the timing and scale of these sorts of events with any precision."

I think what he may be trying to say is that common sense is, after all that talk, not that common and that central bankers cannot be held responsible for their own actions despite the fact that they have taken control over our "paper" world.

Frightening.

As an aside, here's a link to Mr. Bean's remuneration package for 2009/2010.  Lots of paper there.

References:

Charles Bean - Speech to the Royal Statistical Society - October 27th, 2010.