Scott Sumner  

Don't give them anywhere to hide

Medical School: A Whistleblowe... Of Ad Hominems and Incentives...

Tyler Cowen has an interview with Robin Hanson, which is every bit as excellent as you'd expect. Here's a discussion of rationality:

COWEN: For intelligent human beings, collectively, what would be the best way for us to improve rational thinking?

HANSON: Gee, that sounds like a really easy toss-up for prediction markets.


COWEN: To look at prediction markets and to believe them.

HANSON: If we had a lot more prediction markets, then you could just look at the prediction market on any particular question and just believe its answer. That would be the usual way to decide what to believe on a very wide range of topics, and it would be a rational answer.

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I recently did a post discussing what would constitute success for the Hypermind NGDP market. The following comment by Robin has a bearing on that issue:

I would say if you have a project with a deadline today, quite often, that goes badly. That is, you'll have reviews of the project, and people will say, "Yes, of course we're going to make the deadline." Then finally the deadline comes, and you don't make the deadline, and you've failed.

This happens a lot, and if you ask people, "Why does that happen?" they often say, "It was because they wouldn't listen to us about the problems with the project and all the things going wrong, and they kept saying it would work."

If you turn it around and look at it from the guy running the project's point of view, they're thinking, "I might fail on this project. It might not make the deadline. What will my excuse be? I need a good excuse."

Their favorite excuse is usually, "Everything was going fine until all of the sudden, something came out of left field. No one could have seen it coming. It'll never happen again. It knocked us flat, but you don't need to hold anybody accountable or prepare or change it in any way because this was a one-time event."

In order to make that excuse work, you need everybody to say "It's going fine" until all of a sudden, it doesn't. The prediction market gets in the way of that. It shows everybody that from an early point, people knew this wasn't going to work, and so then people will hold you accountable for, "Why didn't you do something about it?"

When it comes to the Great Recession, most people have a faulty memory. Even many famous economists believe the Fed was doing all it could to fight against the effect of "unexpected shocks". Neither claim is true. In 2008, the Fed wasn't even coming close to doing all it could, nor were the shocks unexpected.

Take the famous "Lehman moment". Lehman Brothers failed and this led to a banking crisis, right? It's not quite that simple. Lehman failed on September 14, 2008. Even after it failed, the Fed did not expect a severe recession. However, two days after the failure of Lehman, inflation forecasts in the TIPs market plunged to 1.23% over 5 years. On that day, the FOMC met and decided not to ease policy. Because the banking problems were rapidly reducing the natural interest rate, the FOMC's decision to hold rates at 2% effectively tightened monetary policy. At the September 16 meeting, the Fed hinted that inflation was likely to overshoot their 2% inflation target, thus contradicting the TIPS market prediction.

And that's not all the Fed did. When people point to this discrepancy, Fed officials will occasionally try to discredit the market forecast. They might talk about time varying risk spreads, or market irrationality. They feel it's important to convince the public that the market forecast is not rational, or else the Fed will look foolish for ignoring this warning---especially given that, in retrospect, the market was right and the Fed was completely wrong.

One purpose of creating and subsiding NGDP futures markets is to make it more obvious that the Fed is acting in defiance to market forecasts, when it does so. We don't want Fed officials to be able to say "we never saw that shock coming", when in fact the Fed simply ignored the bearish TIPS market forecast in 2008, a market that certainly did "see that shock coming". We don't want Fed officials to have anywhere to hide.

If Fed officials know that a very public forecast of their goal variable (or even a macro aggregate closely linked to their goal variable) is drifting far off course, it will be harder for them to ignore that information.

Thus one goal of the Hypermind NGDP futures contract is simply to have a market price that is publicly visible. The prediction market becomes a sort of spotlight, shining on the FOMC.

Comments and Sharing

COMMENTS (7 to date)
E. Harding writes:

The reason the Fed was fearing inflation well into September 2008 was because inflation had been showing a fairly consistent trend of increasing since 2002, and it nearly hit 5% during the first half of 2008. This was due at least partly to accelerating gasoline and food prices, which the Fed feared would continue at the time due to high Chinese demand (and reduced supply due to Hurricane Ike-related refinery closures). The first half of 2008 looked a lot more like 1973 than 1929. I remember that time well.

Thomas Sewell writes:
decided not to easy policy
Guessing is a typo for:
decided not to ease policy
Rajat writes:

Agree that should help. Still, one would expect a central bank to be embarrassed about making systematic forecasting errors. Check out this link, which shows how the RBA has systematically over-forecasted wage growth:

Marcus Nunes writes:

Better look "at that time" again:

Andrew_FL writes:

Core PCE inflation-the Fed's preferred metric- was indeed bouncing around 2% annualized month on month change for the first half of 2008.

Compounded annual rates of change (rounded to 1 decimal place), from FRED (series PCEPILFE):

Jan 08: 2.5%
Feb 08: 1.4%
Mar 08: 2.7%
Apr 08: 1.5%
May 08: 2.3%
Jun 08: 2.4%

Meanwhile PCE inflation including food and energy prices was accelerating away from core, peaking at the equivalent of 8.7% annually in June (FRED series is PCEPI if you want to check this)

After June, things changed:

Jul 08: 1.7%
Aug 08: 1.4%
Sep 08: 1.5%

Then in October, the bottom fell out:

Oct 08: -0.1%
Nov 08: -0.1%
Dec 08: -0.3%

E Harding's recollection of events of the first half of 2008 seems roughly correct to me.

Scott Sumner writes:

Harding, Yup, the Fed was looking backwards when they should have been looking forward. That's my point.

Thomas, Thanks, fixed.

bill writes:

Great post.
This was the point I was trying (poorly) to make a short while ago about the somewhat volatile TIPS spread of late.


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