I just can’t get away from this stuff, can I? I had a very lively conversation this week regarding the S&P downgrade of the USA, specifically the $2T ‘error’ in S&P’s math and questions of S&P’s credibility. As a fellow professional prognosticator, albeit in engineering versus finance, I have a unique perspective on these matters that I’ll outline below.
There are two questions I want to address here. First, did S&P really make a $2T ‘error’ in their forecast? I contend that no, they did not make an ‘error’ and merely have a difference of opinion with the government. Second, since I believe it wasn’t an ‘error’, how did the myth that the difference in question was actually an ‘error’ gain such critical mass? I’m going to put this up as a two-parter.
What happened is that S&P and the government have disagreements in the underlying assumptions S&P used in their model with regards to how quickly government spending will rise over the coming years. S&P did not believe the ‘official’ numbers from the Congressional Budget Office (CBO) and made some tweaks. S&P also assumed the Bush tax rates would remain in place. A quick and easy-to-read explanation can be found here. I find this explanation far more convincing and credible than anything the Treasury has said.
On a side note, this also provides an explanation for why my debt/GDP levels are different than S&P’s, namely because I use Total Federal Debt now around $14.5T and S&P uses Federal Debt Held by the Public now around $10T, with the difference being my bigger number counts intra-government or inter-agency and S&P’s smaller number doesn’t. I still maintain my number is the correct one to use.
Forecasting is very difficult to do well for even fairly simple things. The complexity ramps up exponentially as we go out further in time and as we explore bigger, more complicated systems. Also, we have to account for unknowns. Donald Rumsfeld is widely, and erroneously, ridiculed for his famous ‘known unknowns’ quote shown here. It’s actually a very intelligent thought, and mocking Rumsfeld for the quote is beyond absurd.
“Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know.”
Prognosticators cope with the complexities and unknowns by making assumptions. We document and justify those assumptions. Unsurprisingly, people disagree with those assumptions quite often. Disagreement in opinion regarding underlying assumptions doesn’t necessarily mean ‘error’. In this case, increasing the rate of government spending by a couple percent per year is reasonable, but assuming the US will grow GDP at 10% per year for the next decade is unreasonable. Of course, we also have to make room for so-called black swan events, which are low-probability and high-impact events that were generally not on people’s minds. 9/11 comes to mind as a pertinent example here. These events generally don’t find their way into credible forecasts, yet they can alter the end result of how accurate the forecast is.
These differences in underlying assumptions are how two proven forecasters can arrive at two different conclusions given the same set of data. It’s how two different weatherpeople can have two different views of tomorrow’s temperatures and weather conditions. It’s how two investors can look at the same stock, with one coming to the conclusion that the stock is deeply undervalued and buying it while the other thinks it’s way overvalued and shorts it. One could be right, both could be right, or neither could be right. Opinions make a market.
The bottom line is it’s not as black and white as saying a forecast is ‘right’ or ‘wrong’. There’s a lot of grey area to consider. In Part 2, I’ll look at how the error myth reached critical mass.
Links:
http://confoundedinterest.wordpress.com/2011/08/07/treasury-contests-sps-downgrade-because-of-error-even-with-error-u-s-had-to-be-downgraded/
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