April 27, 2018

Could it be that we so much wish some forecasts to be right, that we are unable to see when they fail?

Sir, Miles Johnson ends his discussion of failing economic forecasts with: “It is not surprising that forecasters continue to get things wrong. What remains remarkable is that those who question the assumptions that underpin their repeatedly failing models are still treated as radicals” “Forecasters’ failings highlight the flaws in our assumptions” April 26.

Regulators, they say, based on some careful research, forecasted that what is perceived as risky is much more dangerous to our bank system than what is perceived as safe. And so they gave us risk weighted capital requirements with instance with Basel II’s risk weight of 20% to what is AAA rated and 150% to what is rated below BB-.

The 2007/08 crisis, caused exclusively by assets that because they were perceived, decreed or concocted as safe, residential mortgages, sovereigns like Greece or AAA rated securities, the banks were allowed to leverage much more with, proved without any doubt how wrong that forecast was. 

And there are many more faults with this regulations that completely distorts the allocation of credit to the real economy.

Yet the assumption that underpin that regulation is not questioned, and if someone does, like I have done persistently for about two decades, I get treated like a radical, or at least as someone obsessed that should not be given much voice. 

For instance FT’s Martin Wolf, even though in 2012 he writes: “Per Kurowski reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk”, in the same breath he holds that “it is essential to recognise that so called ‘risk-weighted’ assets can and will be gamed by both banks and regulators”. That of course means Wolf does not see this regulations as something build upon a fundamentally mistaken principle, but mostly just suffering a kind of technical glitch in its execution.

Why is this so? Perhaps it is because we all want so much our banks to be safe, so when regulators tell us the bank capital requirements are risk-weighted, we so much want that to be true that we don’t even dare contemplate the possibility that, the experts, could be 180 degrees off the mark.