Greenspan, Bernanke, and How to Avoid Making Bad Forecasts

In March 2006, Federal Reserve economist David Stockton warned a group of colleagues about the possibility that the housing market was dangerously overextended. "We sense that we're going over the top, but we just don't know what lies below," he said, according to Fed transcripts released earlier this month.

Ben Bernanke, who had just recently taken over as chairman, didn't seem concerned. "Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to-quarter fluctuations," he said.

Later that year, the Fed sent a report to Congress stating clearly: "We have not seen -- and don't expect -- a broad deterioration in mortgage credit quality."

Dallas Fed President Richard Fisher seemed downright dismissive: "As one CEO told me, the only subject that has been more analyzed than the housing situation is the birth of Brad Pitt's baby."

These weren't isolated views. A year and a half before, then-Chairman Alan Greenspan all but wrote off the possibility of a credit bust crippling the economy: "[R]atios of household debt to income appear to imply somewhat more stress than is likely to be the case. For at least a half century, household debt has been rising faster than income, as ever-higher levels of discretionary income have increased the proportion of income spent on assets partially financed with debt." It was all sustainable, in other words.

When it came to the idea that housing was a bubble waiting to burst, Greenspan minced no words: "[I]t would take a large, and historically most unusual, fall in home prices to wipe out a significant part of home equity. Many of those who purchased their residence more than a year ago have equity buffers in their homes adequate to withstand any price decline other than a very deep one."

It's easy to look back at these comments and laugh, scold, and bewail the incompetence of our Federal Reserve. We've all done it. But I don't think it's always the right response. As crazy as these comments seem in hindsight, they were fairly consensus views at the time. Instead of poking at the Fed for missing the housing crash, it's more useful to reflect on why virtually everyone else -- and probably you -- missed it as well.

Try to remember 2005. If you can't, search for some old news articles using Google News. The overwhelming consensus at the time was that, yes, home prices were high, but the most likely outcome was a mere slowdown in the growth rate. At worst, there might be a minor decline.

"We are currently forecasting a plateau in home prices, a moderate decrease in sales and new building and two years of weak growth," wrote one UCLA forecast in 2005.

"We are looking for a slowdown in housing -- no collapse, no awful scenario," forecasting group Global Insight said in 2005.

"Every single thing is pointing to real weakness, but not a collapse, in housing prices. Home values aren't going down. They're simply not going up," TheNew York Times quoted another economist as saying in 2005.

And so on.

Some did predict the housing collapse, of course. But most of those who did ended up being right for the wrong reason. Peter Schiff is a good example. Held up as one of the few who predicted the financial collapse, Schiff is now a virtual god among pessimists. But as I've written before, Schiff was very wrong on what would ultimately cause the crisis, predicting that things would unravel as interest rates surged and the dollar collapsed. Neither happened -- quite the opposite. And being right for the wrong reason doesn't make you right. It makes you lucky.

So why did the Fed and so many others miss the collapse that now seems obvious in hindsight? I think that question answers itself. So much of how we perceive the world today is guided by hindsight. Hindsight today tells us that the housing crash was obvious and unavoidable. But hindsight in 2005 gave us the impression that housing was invincible, rising every year for as long as most could remember. The feeling was just as strong -- just as obvious -- back then as it is today.

The two are somewhat different. Today we're looking backward and talking about what happened in the past; in 2005 we were looking forward and predicting what would happen in the future. But both relate to one of the most powerful theories in behavioral psychology: recency bias.

Recency bias is simply the tendency to think the future will resemble the past. We all do it from time to time. Most of us did it in 2000 when we thought the economy was unstoppable, in 2005 when housing looked like a surefire bet, and in 2009 when we thought the world was coming to an end.

The Fed is just as susceptible to these biases as anyone else (maybe more so). Consider another Greenspan quote from 2005: "Outright declines in mortgage debt seem most unlikely. Home mortgage debt has increased every quarter since the end of World War II." That's an incredible statement when you think about it. The idea that housing won't collapse because it hasn't in a while isn't based on any rational analysis. It's an almost self-proclaimed example of recency bias.

Just because the Fed had more data or more Ph.D.s doesn't mean it had a better grasp on the future of the economy (probably less so). The best investors, the best economists, and the best forecasters in most industries typically aren't the ones with the highest IQs. They're the ones who have the most control over their emotions and who don't get caught up in biases.

So how can you protect yourself from making bad forecasts? Investor Howard Marks recently sent a letter to his clients with a line that I think explains exactly how: "In any endeavor involving uncertainty, not knowing what lies ahead isn't nearly as bad as thinking you know if you don't."

The best way to handle the blunt fact that we're hardwired to make bad forecasts is to accept it. Looking back at the financial crisis, the people who came out relatively unharmed weren't the ones who saw the collapse coming. They were the ones who knew all along that nothing was certain, things change, people act irrationally, markets fail, information is incomplete, and above all, you have to be prepared for the unexpected. The biggest irony is that those who thought they knew the most were the most susceptible to being wrong.

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At the time thisarticle was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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