Book Review: Economics for Independent Thinkers
“Academic economics is full of smart people doing stupid things,” writes investment strategist Daniel Nevins, CFA, borrowing an expression from a former colleague. In the 1960s, policy-making economists proclaimed that recessions had become preventable events, only to witness four recessions between 1970 and 1982, including two particularly severe ones. Prior to the Great Recession, says Nevins, a veteran of J.P. Morgan and SEI Investments, mainstream economists incorrectly argued that house prices could not decline on a nationwide basis.
In Economics for Independent Thinkers: A Practical, No-Nonsense Guide to Understanding Economic Risks, Nevins recounts his evolution from quantitative analyst to thoroughgoing skeptic about the application of quantitative methods to economics. He criticizes the dominant Keynesian and monetarist schools and lauds several earlier, classical economists. The Austrian School, Joseph Schumpeter, and Hyman Minsky similarly deserve greater attention, in his view, than they are receiving today.
Nevins, whose research on behavioral economics has appeared in the CFA® Program curriculum, disdains economists who exhibit “physics envy.” He is especially scornful of those who strive to make reality fit their models rather than the reverse. Nevins argues that conventional economists are wrong to deny that the banking system creates credit. They cling to the orthodoxy that deposits invariably precede loans, whereas, in reality, he says, banks make loans and then generate deposits. That activity helps drive economic expansions to excess, setting the stage for subsequent contractions. The existence of virtuous and vicious cycles contradicts the mainstreamers’ assumption that markets and economic forces always automatically self-correct. The reason conventional economists fail to foresee recessions, according to Nevins, is that they are not looking for them.
Conflicts of interest, Nevins maintains, undermine the reliability of economic forecasts published by financial firms. In essence, customers reliably buy the investment products that are most profitable to the forecasters’ firms when they are induced to feel bullish. Nevins cites one epic January 2007 report that heralded a surge in global liquidity supposedly destined to sustain long-lasting prosperity. It proved to be, instead, a massive debt bubble that was already beginning to deflate. The following year, a prominent research firm that caters to major banks and hedge funds ridiculed pundits who were expecting a recession. The researchers repeated their optimistic message all the way until the shock of the September 2008 Lehman Brothers bankruptcy.
For practitioners, the book’s value lies less in Nevins’s critique of model-driven economic forecasting than in the historical-based methodology he offers as an alternative. Nevins provides a checklist of indicators designed to predict spending and production. They fall into three categories — Fundamentals (housing investment, household earnings, and the foreign sector), Confidence (house prices, stock prices, household credit conditions, and business credit conditions), and Public Policies (monetary policy, fiscal policy, the rule of law, regulations, public goods, infrastructure, and state-run and state-backed companies).
Nevins’s approach calls for investment managers to use qualitative judgment in assigning priorities to the indicators. In addition, any indicator may be overridden if some statistical quirk threatens to make it emit a false signal. Nevins also points out that “there is no hard-and-fast rule when it comes to the sequence of events that shapes the business cycle.”
The author’s backtesting indicates that his composite of indicators has historically outperformed the consensus in forecasting recessions. Even so, he does not encourage readers to rely solely on the composite. He cites the example of the 1953–54 recession, which would have been unforeseeable without considering the unusual factor of a collapse in military spending following the Korean War armistice.
Upholding the rule that no one writes a perfect book, this one contains some minor errors. For example, Nevins incorrectly attributes Henrik Ibsen’s remark that the majority is always wrong to Mark Twain. He erroneously describes an aphorism almost certainly authored by efficiency engineer Harrington Emerson as an American proverb. Finally, Nevins perpetuates the urban myth that frogs are oblivious to being boiled to death gradually.
Notwithstanding these small flaws, Economics for Independent Thinkers is useful to practitioners who make economic forecasting part of their investment process. It highlights practical difficulties with such standard methods as the coincident or lagging nature of consumer confidence surveys and the time lags built into production and employment indicators. Readers may also appreciate Nevins’s enlivening of potentially dry subject matter with frequent pop culture allusions and analogies.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.