The Massive Macroeconomic Crisis

Maybe I should be using my economics degree as a tissue.

Sounds harsh, I know, but can you blame me? Most schools of economics completely missed the oncoming financial freight train that smashed into the United States. As for the schools that claim to have been right on top of the situation, they had largely been calling for it way too far in advance. Can you imagine if a weather forecaster called for a Category 5 hurricane every day for two years and then took credit when one finally hit?

But for all the holes we can blow through this somewhat smeared social science, the assumption of rationality may be one of the biggest. In a recent FT.com article, University of Leuven professor Paul De Grauwe took macroeconomics to task in general, but highlighted economic models' assumption that we all act rationally as a core problem with the discipline.

Need I mention Gary Busey?
Busey is fun to mention because he's said some rather irrational things -- "When you get lost in your imaginatory vagueness your foresight will become a nimble vagrant." -- but it's really impossible for any of us to claim consistent rationality.

Whether we like it or not, our brains are wired in such a way that our actions can often stray very far from rationality. And while economists like to believe that temporary irrationality in some "agents" in the economy is balanced out by other agents, unfortunate behaviors like the bandwagon effect can blow that assumption way out of the water. And for those economists with their heads still in the sand, I'd ask where the rationality was when it came to AIG (NYSE: AIG  ) , Citigroup (NYSE: C  ) , or Lehman Brothers.

And while I'd love to go on ripping apart rationality, author Jonah Lehrer actually did a much better job than I ever could in this recent episode of "Motley Fool Conversations."

Eggheads with models
No, I don't mean rich nerds dating Victoria's Secret women, I'm talking about smart folks trying to get too cute with financial and economic forecasting models.

At this point I think many of us have come to the conclusion that complex mathematical models created by financial eggheads -- whether at the yet-successful Goldman Sachs (NYSE: GS  ) or the disastrous Bear Stearns -- helped bring us to the financial brink.

While there are a host of problems we can point to with these models -- including inspiring overconfidence -- this issue of rationality is a huge tripping point. Many of these models relied directly on some assumption of rational investors, but pretty much all of them leaned on economic forecasts that came from models that used rationality as a key starting assumption.

As I learned from my days as a computer programmer -- garbage in, garbage out. Relying on this nonexistent rationality makes the output of most economic models about as useful as a winter parka at midday in the Kalahari Desert.

Can we divorce economics?
Investors will have a tough time -- and by "tough time," I mean "impossible time" -- avoiding the impact of the economy on their investments. After all, Amazon.com (Nasdaq: AMZN  ) will be able to sell more books, DVDs, and Kindles, and Dell (Nasdaq: DELL  ) will sell more computers when the economy is roaring along.

But even if we can't sidestep economic outcomes, we can expend fewer braincycles dizzying ourselves with the myriad contradicting economic predictions. Peter Lynch, one of the greatest investors to have run major money, once said "I spend about 15 minutes a year on economic analysis."

Skip that, do this
There's no need for a complex economic model to learn more about the management team at Whole Foods (Nasdaq: WFMI  ) , and you don't need to run any multivariate regressions to learn more about Activision Blizzard's (Nasdaq: ATVI  ) strategy. (You can find it in its second-quarter slide presentation and its most recent annual report).

And while all companies are beholden to the economy to some extent, having the very best companies in your portfolio will give you the best chance for long-term outperformance even without correctly reading the short-term economic tea leaves.

Have some thoughts (or complaints!) of your own about macroeconomics? Scroll down to the comments section and let me know what you think.

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Amazon.com, Activision Blizzard, and Whole Foods Market are Motley Fool Stock Advisor recommendations. Dell is a Motley Fool Inside Value pick. Berkshire Hathaway is a Motley Fool Stock Advisor and Motley Fool Inside Value pick. Try any of our Foolish newsletters today, free for 30 days

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool's disclosure policy already used Matt's economic degree as a tissue. Shhhhh, don't tell him.


Read/Post Comments (9) | Recommend This Article (19)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 07, 2009, at 6:05 PM, plechawski wrote:

    very realistic article, so many people will get hurt, what a shame bud it will happen, just timing when , I believe right after summer when summer jobs and turism will go for long rest and unemployment will shot double digits, goldman sachs knows, they are in charge of wall street , they also own our new president

  • Report this Comment On August 08, 2009, at 1:04 AM, memoandstitch wrote:

    The people who made subprime decisions at AIG and other institutions were totally rational. They maximized their expected compensation. If you have two options:

    1) gamble with somebody else's money and retire within a year

    2) don't gamble and get a normal salary for 20 years

    Which one would you choose?

  • Report this Comment On August 08, 2009, at 3:14 PM, ozzfan1317 wrote:

    Lol..Sad but true I would like to retitre within a year myself..lol

  • Report this Comment On August 10, 2009, at 8:47 AM, johnfinnan wrote:

    "Can you imagine if a weather forecaster called for a Category 5 hurricane every day for two years and then took credit when one finally hit?"

    That is not really a fair comparison. Many of the people who were predicting this crisis knew it to be inevitable unless drastic actions were taken, but would have found it impossible to predict exactly when the hammer would fall. They also were not (to my recollection anyway) prophesying that the hammer would fall every other week.

    If you must stretch to a weather based analogy, they are like those who predict a tipping point crisis in global warming. They are not saying exactly when it will happen. Only that it is inevitable, given our current practices.

    Doubtless, should it occur, there will be many who will cry "We couldn't have known". Those who refuse to learn from history, etc.. etc...

  • Report this Comment On August 10, 2009, at 10:15 AM, carbonsink wrote:

    Here's one way to predict a recession: when things (paycheques, portfolios, etc.) are good enough that a sizable portion of the working population are planning to retire early, things will then go sour. Its almost a law of physics since the economy won't allow it.

  • Report this Comment On August 10, 2009, at 7:38 PM, JohnG25 wrote:

    Yes the The Eggheads Blew It. Another area where they may be blowing it is global warming. Most conclusions on global warming come from complex computer models some with questionable inputs. And sometimes the Eggheads have a lot to gain with the outcome of their models, i.e. move and bigger grants when the get the "right" conclusions. Computers are great tools, but GIGO.

  • Report this Comment On August 10, 2009, at 8:56 PM, xetn wrote:

    The Austrian School of Economics have predicted almost every single recession (including the great depression). They have been able to do this based on the Austrian Theory of The Trade Cycle. This is based on central and fractional-reserve banks creating massive credit expansions based on artificially low (sub-market) interest rates, causing booms and resultant busts. The dot.com and housing boom are excellent examples. But no one can accurately time any economic event.

  • Report this Comment On August 10, 2009, at 10:30 PM, kokomojo1066 wrote:

    Anytime many many people live beyond their means; folks mortgage the roof over their heads to buy consumer goods; corporations pay top officers more money than God while the lesser mortals are paid the same minimum years for --is it TEN--years at the same time the prices of goods and food go into overdrive; and while those who depend on interest as part of retirement income watch interest dry up (no doubt to force retirees into the stock market to keep THAT up), and while manufacturing is moved offshore and millions of people are left unemployed, then anyone who has paid any attention to the world can see that it had to hit the wall at some point. Just as the cheerleaders for ever more and more of everything refused to face reality, so do the global warming nay-sayers, who refuse to pay attention to Greenland and Alpine glaciers melting, while the air conditioner that is the arctic turns from white snow to dark waters, leading to global cooling. When crops fail all over the globe because there is no glacial melt to water the fields, then the feathers really will hit the fan. I hope I'm dead by then so I don[t have to be treated with contempt by those who refuse to pay attention to either economic reality or what's looking them right in the eye. Not to mention I don't want to have to protect my water source from people who want mine when their's is gone.

  • Report this Comment On August 10, 2009, at 10:31 PM, kokomojo1066 wrote:

    Whoops, sorry, I meant to write global warming when the oceans are dark water instead of snow white.

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