Feedback effects: Why NO ONE knows how bad things will get

When economies go haywire, forecasters look stupid because most forecasts use an algorithm that basically says “next year will look a lot like this year plus one year’s worth of trend growth.” If the trend growth rate is 2% per year, then next year will be like this year plus 2% growth.

Such simple models work reasonably well in “normal” times. But when they’re wrong, they can go horribly wrong. Why do forecasting models break down so quickly and completely?

A big reason is feedback effects. In economic equilibrium, small deviations from trend tend to adjust back toward the trend. But when any significant economic sectors or components of GDP swerve badly off course, all bets are off for the entire economy due to feedback effects.

I was reminded of this while reading “For Housing Crisis, the End Probably Isn’t Near”:

The glut of foreclosed homes creates a self-reinforcing cycle. Falling prices lead to more foreclosures. Foreclosures lead to an excess supply of homes for sale. The excess supply then leads to further price declines.

Another New York Times article, “As Housing Market Dips, More in U.S. Are Staying Put” mentions another feedback effect:

The number of people who changed residences declined to 35.2 million last year, the lowest number since 1962, when the nation had 120 million fewer people.

Experts said the lack of mobility was of concern on two fronts. It suggests that Americans were unable or unwilling to follow job opportunities around the country, as they have in the past. And they said the lack of movement itself could have an impact on the economy, reducing the economic activity generated by moves…

The American Moving and Storage Association said the number of people changing residences has been dropping for four years and fell 17.7 percent between 2007 and 2008.

Americans long took labor mobility for granted. It was easy to sell your house for a profit, easy to get a mortgage, and easy to buy a new — probably bigger — house with profits from your house sale. Consequently, moving to take a better job was simple, even if you had just lost your job.

But the current crisis has made it very hard to sell your home and harder still to borrow to buy a new home (esp. if you’ve lost your old job). So, many people are trapped in their current homes. Some of them have better opportunities elsewhere but can’t move. This hurts them (and their families) directly. It costs the government tax revenues. It costs real estate agents and mortgage companies. And it harms businesses who can no longer hire the best person for each job due to real estate market friction.

This is just one domino among many that have toppled — and will continue toppling — as our economy spirals further downward. Because the quantity, magnitude and interactions among these feedback effects are so large, no one knows how bad things will get. No forecasting model can forecast the economy with much precision. That’s a scary thought.

And — as if to prove my point — this economic uncertainty itself is another powerful domino knocking the economy even further below “normal” equilibrium. If businesses don’t know when the economy will turn around, they’ll eliminate jobs, slash costs and cut production… thereby accelerating the downturn and generating even more fear and uncertainty.

Posted by James on Wednesday, April 22, 2009