WHY TAKE THIS SERIOUSLY?

For well over a century, statisticians have known that predictions made by large numbers of people – over a thousand – are more accurate than predictions made by experts. This phenomenon was discovered by Charles Darwin's cousin, Francis Galton, who was a statistician. He did an experiment at a county fair. He asked a large number of attendees to estimate the butchered weight of an ox. There was a contest to see who could estimate it most accurately. He found that the average of the estimate was more accurate than the guesses made by livestock experts.

This phenomenon has been repeated for over a century. Again and again, the results are the same. An average of the guesses turns out to be very accurate. This fact and some of its implications were summarized in a best-selling book in 2004, The Wisdom of Crowds, by James Surowiecki.

Over the last few years, there have been several websites set up that allow people to guess about future events. Some of them use play money to stay out of the government's clutches. One is set up as a commodity futures exchange, which is legal for bets (investments) under $500. Then there are the foreign gambling sites.

These sites post the results of the bets. They publish charts. I monitor some of these charts, just to see what's happening in the world of non-sports betting. I especially pay attention to sites where gambling is for real money. Intrade is one of the largest. It merged with TradeSports several years ago.

Galton's discovery confirms an important insight of free market economists, most notably F. A. Hayek. In his most important article, "The Use of Knowledge in Society" (1945), Hayek argued that central economic planning cannot be as efficient as free market economic planning because central panning boards cannot accumulate or accurately assess the information possessed by the investing public. Knowledge is decentralized. No man knows more than a sliver of this knowledge.

The supreme task of society, Hayek argued, is to gain access to the best knowledge available. This can be done only through private ownership, the legal right to exchange, and the profit-and-loss system. Central planning interferes with all three.

Galton's discovery is a specific application of Hayek's general theory regarding decentralized knowledge. It seems that the highly specific knowledge possessed by large numbers of people is superior to expert knowledge possessed by a handful of individuals.

This is bad news for investment advisors as well as central planners. I think this is why we see so few references to these new prediction market sites. Investment advisors do not want to think a bookie has access to more accurate knowledge than they do.

The thought that the bookie then posts a chart in the free section of his website . . . well, it's clearly un-American. I know this must be true, because when a free market economist, Robin Hanson, recommended the creation of a betting site for future terrorist acts, in order to better assess their likelihood, there was such a firestorm of criticism from Congress that the Defense Department dropped the idea the day after news of the suggestion hit the media. When a free market solution for a better system than the colored terrorism alert system used by the government, Congress saw red. That was in 2003. It seems even more un-American today.

Yet few Americans know that this same technique was used in 1968 to locate the sunk American submarine, The Scorpion. I first read about this years ago in the book, Blind Man's Bluff. It had been recommended to me by a retired captain of a submarine. This story is summarized by Prof. Arthur Rubenstein.

The Navy had all but given up hope of finding the submarine when John Craven, who was their top deep-water scientist, came up with a plan which pre-dated the explosion of interest in prediction markets by decades. He simply turned to a group of submarine and salvage experts and asked them to bet on the probabilities of what could have happened. Taking an average of their responses, he was able to identify the location of the missing vessel to within a furlong (220 yards) of its actual location. The sub was found.

IF THIS IS NOT A RECESSION. . . .

So far this year, we have seen a higher unemployment rate, a decline in the median price of the American home, widespread consumer pessimism, rising personal debt, a manufacturing sector in a recession (reports the Institute for Supply Management), large commercial banks in big trouble for bad mortgage loans, the financial industry in turmoil (Bear Stearns, Carlyle Capital Group), the threat of a bailout by Congress of foreclosed houses, a decline in sales in the auto industry – even Toyota – with no end in sight, and the Federal Reserve System in panic mode. Even Warren Buffett's Berkshire Hathaway shares have fallen from $150,000 to $125,000 since mid-December. Yet, in terms of the GDP figures, the economy is not yet in a recession.

If this is not a recession, I don't like to think about recession.

The fact that European gamblers do not think the U.S. will have a recession in 2008 is good news, but how good? With non-recession economic conditions what they have been so far this year, the good news is consistent with continuing bad news. It just isn't super-bad news.

The U.S. stock market has not reflected a shift in opinion comparable to the magnitude of the shift on Intrade. It is still below 14,000, which it reached last November.

Interest rates on Treasury debt is low, with T-bills under 2%. This is consistent with fears of recession. Investors are accepting a taxable rate of return that is below the official rate of price inflation. Why are they willing to do this? Because they fear the loss of their capital.

If investors believe that a boom is imminent, they would shift back to the stock market. So far, they haven't.

WHICH STOCKS?

There is an addiction known as "buy a stock index fund and hold." I call it an addiction because, ever since its peak in March 2000, stock indexes have fallen. The NASDAQ is less than half of where it was in 2000. The S&P 500 is down from the mid-1500's to the 1400 range. The Dow Jones Industrial Average is up slightly, but not if we factor in the 21% increase in consumer prices. Yet at no time did the "buy and hold" crows ever tell their readers to get out of stocks. I did: in February and March of 2000.

So, these people have been conditioned to ignore economic reality. No matter what happens, they are told to buy and hold. When the indexes are down, eight years after their peak, the "buy stocks" promoters start recommending sectors. But this advice is counter to the original "buy and hold a no-load index fund." This is speculating to beat the indexes. This is inconsistent with the buy-and-hold theory.

I realize that most of my readers hold stocks. They have taken a beating for eight years, but they still believe the experts. (By the way, the experts also did not forecast the decline in housing prices. I started warning readers to get out in April of 2005.)

If you own stocks, why not Asian stocks? Asia is clearly the wave of the future. They are where the economic growth is. Why buy shares in a low-growth nation that is running a $700 billion to $800 billion balance of payments deficit every year? Why buy the shares in a nation whose national government is running $400 billion annual on-budget deficits and has an unfunded off-budget Social Security/Medicare liability of over $70 trillion?

Most important, when your income is in dollars, shouldn't your investments be in assets denominated in foreign currencies? Isn't this what portfolio diversification is all about? Of course it is, but the experts rarely mention that, in order to be diversified, you retirement portfolio must be diversified out of the currency unit in which your monthly salary is denominated?

I am not convinced that the Asia's stock markets will rise during the later phases of the real estate crisis. This crisis is international. It has barely begun. But if you use a buy-and-hold strategy, the case for Asian stocks is far stronger than the case for American stocks.

DEBT

The American economy is Keynesian. It is debt-driven. Every aspect of it rests on the increase of debt. Yet it is already the biggest debtor nation in history.

Private household debt is under significant pressure today. With the reversal of housing equity, the home equity loans, called HELOCs, are becoming more difficult to secure. People need higher credit scores. As the housing market continues to suffer equity losses, banks will be forced to reduce this lucrative source of income.

When will this happen? I think it will happen in September, when the summer house-buying season is over and the foreclosure market is still glutted with unsold, empty houses. The lenders will have to begin to foreclose in earnest this fall. We have seen only the preliminary phase of foreclosures so far. The lenders are hoping against hope that the borrowers will be able to make payments again. This is not going to happen.

In my previous report, "Real Estate Maps of Doom," I discussed the extent of the crisis. It pointed to the institutional problem facing the lenders: centralization. This is the product of government intervention into the housing market coupled with academic theories of asset pricing that ignored the effect of the policies of Greenspan's Federal Reserve era. I wrote:

The lenders are huge, centralized conglomerates. They bought pooled packages of real estate loans. This was all very scientific, the lenders were told. It diversified risk.

This crisis is not like previous housing crises. There is no local banker who made the loan with his bank's assets. There is therefore no highly motivated local seller of a foreclosed property. There is no one locally with the authority to negotiate. Centralization lowered costs getting into the deals. It has dramatically increased costs of getting out.

But the foreclosure system is paralyzed. The locals have no authority to negotiate. The distant bureaucrats are insulated from reality. They dream of a government bailout. They don't want to sell at the newer, lower prices, because this will force them to write down their loans' value. They refuse to declare losses that the market has already imposed.

I am not willing to dismiss this betting market. This is the best single indicator that has signaled "no recession." I take it far more seriously than I do any forecasting service that did not issue a warning in 2007 regarding the seriousness of this year's economy.

CONCLUSION

The American economy has two major engines of growth: the housing market (debt) and the auto market (debt). Both are in recession.

The service sector may withstand the crisis in the largest manufacturing sectors. It may smooth out the economy so that it does not fall into recession, as defined – meaning undefined – by the National Bureau of Economic Research. The head of the NBER, Martin Feldstein, thinks the American economy is headed into recession.

Nevertheless, I am now ready to accept the counter-estimate of a bunch of faceless gamblers in Europe who have their own money on the line.

This is a case for optimism. It is not much of a case, but it's the best anyone has offered so far this year.

I think the recession will arrive this year. I do not expect a severe recession. I also do not think the recovery will be strong or rapid. The slowdown will last for over a year. So will a depressed housing market. But I do take seriously Intrade's assessment. We are less likely to have a recession than we were as recently as mid-April.

May 15, 2008

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2008 LewRockwell.com

-- Posted Thursday, 15 May 2008 | Digg This Article