Leithner Letter for the month ended July 31, 2017; titled, “Experts Can’t Predict – Yet Investors Must Plan.”

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Though it is not yet clear just how the long expansion might end, there are three likely possibilities. First, it might run out of steam as demand fizzles. Second, the Asian depression might overwhelm earnings prospects, stock market values and hence household confidence. Finally, Federal Reserve Chairman Alan Greenspan might, in time-honored fashion, murder the expansion before it gets a chance to die of old age. But each of these possibilities is remote. The U.S. economy likely will not see a recession for years to come. We don’t want one, we don't need one, and, as we have the tools to keep the current expansion going, we won't have one. This expansion will run forever.

Rudi Dornbusch

“Growth Forever” (The Wall Street Journal, 30 July 1998)

The stability of the economy is greater than it has ever been in our history. We really are in remarkable shape. It’s amazing that people … write stories about how bad the economy is … The U.S. is at the peak of its performance … there’s never been a time when we’ve had a state of prosperity … a level or spread, [like] we’ve had in the past ten or fifteen years. And I think that Alan Greenspan’s monetary policy is primarily responsible for it.

Milton Friedman

Interview with Charlie Rose (2005)

I think the [financial] system is much safer and much sounder [than it was a decade ago]. We are doing a lot more to try to look for financial stability risks that may not be immediately apparent but to look in corners of the financial system that are not subject to regulation, outside those areas in order to try to detect threats to financial stability that may be emerging. … Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.

Janet Yellen

Banks “Very Much Stronger;” Another Financial Crisis not Likely “in Our Lifetime” (CNBC, 27 June 2017)

Experts Can't Predict - Yet Investors Must Plan

It’s unwise to allow experts’ predictions to determine one’s investment decisions. Authorities generally don’t provide reliable guides to the future: indeed, the more confident is the expert, the less accurate, on average, will be his prediction – and therefore the poorer will be any resultant decision.1 Yet investment reflects particular (albeit perhaps tacit) assumptions about the future; so does choosing a career, resolving to marry, starting a family, buying a house, retiring, etc. More than mere guesses or wishful thinking must justify such actions.

What, then, to do? Investment is a process that generates decisions; accordingly, as part of this procedure investors must understand that

1. the predictions of experts – including the world’s foremost economists’ assessments about the business cycle, rates of interest, etc., are typically less reliable than random guesses or tosses of a coin;

2. how we think about the future in general (rather than what we think about specific aspects of it) can provide justifiable means to navigate through its fog of risk and uncertainty.

A Short History of Predictions of the Price of Oil

The logic is valid and the evidence is unambiguous: no matter what we consider expertise and regardless of their area of speciality, experts can’t dependably predict the future. Indeed, their record is typically so abysmal that, when it comes to the future, it’s tempting to regard “experts” as “anti-authorities.” Clearly, it’s essential to assess their predictions very sceptically; historical perspective and a wry sense of humour are also vital. U.S. President Jimmy Carter’s Address to the Nation on 18 April 1977 – known as his “moral equivalent of war” speech – provides an excellent example (see also James Reston, Moral Equivalent of War, The New York Times, 20 April 1977). “Tonight,” Carter told his countrymen,

I want to have an unpleasant talk … about a problem unprecedented in history. With the exception of preventing war, this is the greatest challenge our country will face during our lifetimes. The energy crisis has not yet overwhelmed us, but it will if we do not act quickly.

Carter was hardly the first politician who resorted to hyperbole. Apart from war-time, however, he was among the first (and, I boldly predict, won’t be the last!) to use passages like “this is the greatest challenge our country will face during our lifetimes.” He was perhaps the only American president who began a speech by telling his audience that it would be “unpleasant.” And it was: that night he asserted that the U.S. – indeed, civilisation itself – was in peril. The next several years, he declared, would be hard. They would demand sacrifice and struggle – because, he alleged, “the oil and gas we rely on for 75% of our energy are running out.” Moreover, “unless profound changes are made to lower oil consumption, [my expert advisers and I] now believe that in the early 1980s the world will be demanding more oil than it can produce.” Because demand would undoubtedly continue to outstrip supply, the price would soar. Indeed, Carter – backed by a consensus of experts – was certain that it would “never” fall.

That was the benign scenario. Actually, he reckoned, things would probably be worse: if the world’s consumption of oil continued to rise “by 5% a year, as it has in the past, we could use up all the proven reserves of oil in the entire world by the end of the next decade.” The president warned that “nothing short of nuclear war” could damage the U.S. more grievously. Cheap oil had fuelled its – indeed, the Western world’s – great boom of the 1950s and 1960s; and the resulting era of mass prosperity made Americans the envy of much of the world. Inexpensive petroleum enabled the development of vast tracts of suburban housing, the national motorway system – and ordinary people’s ability to buy an affordable car and drive wherever their desire took them. Low-cost oil was the very lifeblood of the American way of life.

The OPEC oil embargo of 1973 – which inflicted petrol shortages and triggered a deep recession – underscored its vital importance. Yet most Americans believed that the end of the embargo meant that abundant supplies and good times would soon return. Carter sought to dispel this fond wish:

I know that some of you may doubt that we face real energy shortages. The 1973 [queues] are gone, and our homes are warm again. But our energy problem is worse tonight than it was in 1973 or a few weeks ago in the dead of winter … and it will get worse every day until we act.

Carter used “energy alarmism” as a rhetorical prod with which to badger Americans until they amended their behaviour to suit his ideals. Consumption, he insisted, must henceforth cease to be the foundation of the U.S. economy and the American way of life. No longer could growth – that is, the improvement of living standards – be the objective; instead, conservation must take priority. Abstention would entail a huge effort, he warned; indeed, it was “the moral equivalent of war.” This “war” would, of course, necessitate sacrifices – and average people would have to bear the brunt of them. But there was no choice: “the alter-native may be national catastrophe.”

In retrospect, Carter’s speech was significant in two respects. First, by cribbing the phrase “moral equivalent of war” (from a 1906 essay by the American philosopher and psychologist, William James), Carter’s minders handed his Republican opponent at the election of 1980 – the sunny optimist, Ronald Reagan – one of the most devastating acronyms (MEOW) in American political history. Second, Carter’s deeply pessimistic forecast proved wildly inaccurate. For a couple of years, though, it didn’t seem egregiously wrong. Quite the contrary, to most experts it seemed unarguably correct. In 1978, in the wake of OPEC’s embargo, the price of oil remained more than twice its average of the 1960s. Then, in 1979, the Iranian Revolution2 slowed the flow of crude from the Persian Gulf – and its price skyrocketed another 70%. Long queues at petrol stations reappeared and the foundations of American civilisation again seemed fragile. A low-budget Australian movie, Mad Max, extrapolated this trend into the future. It depicts a dystopian world whose supply of oil has virtually disappeared and where civilisation has thereby collapsed.
But the disruption triggered by events in Iran didn’t last. Specifically, actors responded to price signals: beginning in 1980, the surge of oil’s price triggered a wave of exploration, a burst of discovery and a gush of new supply. In response, what Carter said would never happen did occur: prices drifted lower. Then, from September 1985 to March 1986, it collapsed 70%. Oil hadn’t been that cheap since before the 1973 embargo. And it remained inexpensive: in CPI-adjusted terms, 20 years would pass before it was again as costly as it was when Carter warned that its supply would soon run dry and its price skyrocket.

Leithner Letter August 2017

Carter’s dour prediction of the late-1970s was thus, by the mid-1980s, laughably inaccurate. Today we don’t recall the 1980s as years of austerity and crisis. Quite the contrary: they’re usually remembered (fondly or otherwise) for hedonism and growth. In the sense that the buck stops on the president’s desk, Carter’s enormous miscue was his own damn fault. But he didn’t originate the idea that the supply of oil was dwindling, an energy crisis beckoned and therefore that higher prices were inescapable. He restated what his advisers had told him; his advisers, in turn, merely relayed to him the consensus of oil experts; and these experts weren’t just confident or passionate: they were apocalyptic. “All available evidence,” warned Ulf Lantzke, the head of the International Energy Agency in 1978, “points to a serious risk of a serious energy crisis in the middle of late 1980s.” “Putting it simply,” he told The New Republic (25 February 1978), “there is a very great likelihood of a major worldwide depression.”3

Specialists were hardly unaware that new sources of supply – in Alaska, Canada, the North Sea and elsewhere – would commence production in the early 1980s. But their pessimism was such that these discoveries would merely postpone the day of reckoning. Some thought that the squeeze would start in the early-1980s; others thought it would occur late in that decade; but almost none doubted that the storm would erupt before long. “Though variations were to be found among the forecasts,” wrote Daniel Yergin in The Prize: the Epic Quest for Oil, Money and Power (The Free Press, repr. ed., 2008), a history of the oil industry,

There was considerable unanimity on the central themes, whether the source was the major oil companies, the CIA, Western governments, international agencies, … international experts or OPEC (p. 653).

It’s important to emphasise the apocalyptic tone of authorities’ predictions, as well as the self-righteous flavour of their responses to allegedly impending Armageddon. During these years, experts about energy in general and oil in particular (and the bureaucrats, journalists, politicians and others who shared their zeal) didn’t just claim that, factually, they knew more than the man in the street: they contended that, morally, they knew better than he did what was good for him – and they insisted that he’d get it whether he wanted it or not. During the Carter presidency, “insiders”– that is, those whose views mattered – emphatically agreed (in the words of Tom Wicker, a columnist in The New York Times) that there wasn’t merely an energy crisis: “it was real, growing and a grave threat to modern civilisation” (Carter’s Oil Problem, 4 March 1977). Jimmy Carter didn’t just tell Americans what anointed experts had told him; he told benighted Americans (i.e., those whose views didn’t count) how elites demanded they must henceforth live their lives.

Bless them, the American public refused to toe the line. Poll after poll showed that a majority thought that oil prices were like hemlines – that is, they rose and fell from season to season. This stoic rather than self-righteous attitude irked ordinary people’s supposed betters. “There should be no such thing as optimism about energy for the foreseeable future,” The New York Times, the house organ of those who presume to know best, sternly lectured the reprobate masses in 1980 – just as prices approached their peak. “What is certain,” it instructed the untutored, “is that the price will go up and up, at home as well as abroad.” Insiders consoled one another: many Americans simply but inexplicably failed to under-stand (or accept) “the facts.” In 1977, A New York Times/CBS poll found that more than one-half of tertiary-educated Americans believed that an oil shortage exist-ed – and that barely one-quarter of those with a high school certificate or less agreed. The problem, the anointed whined, was that benighted Americans

were surprisingly ignorant of some basic energy facts. Despite all the publicity over the past four years about rising oil imports, which currently account for almost half the country’s total energy needs … one-third of those polled thought the U.S. produced all the oil it requires. … Only 48% knew the U.S. must import oil … The survey strongly suggests … that the public’s willingness to shift priorities for the sake of energy [conservation] depends not so much on what they can afford to do, as on how convinced they are of the need to do so (Anthony Parisi, “Poll Finds Doubt on Energy Crisis,” The New York Times, 1 September 1977).

President Carter, too, was frustrated that the unwashed wouldn’t obey him. Indeed, they largely ignored him. On 23 May 1979 he whinged:

The American people have absolutely refused to accept a simple fact. We have an energy crisis. We have shortages of oil. The shortages are going to get worse in the future. We’re going to have less oil to burn, and we’re going to have to pay more for it.

By the mid-1980s, the dour Carter had been ejected from the White House, the sunny Ronald Reagan occupied it – and the world was awash in cheap oil. It’s tough being a bright expert: not only are your predictions almost always wrong; even worse, with respect to the really big questions the supposedly dim masses are more likely to be right! Affordable oil – the polar opposite of what the expert consensus of the 1970s had stridently prophesied – characterised the years from mid-1980s to the late-1990s. In response, producers slashed their costs and thereby restored their profitability. But forecasters learnt nothing from – and certainly didn’t apologise for – this appalling blunder; nor did the general public consign to the dust-bin the notion that experts could reliably predict oil’s price. Instead, failed fore-casts were quietly discarded – and equally-confident ones took their place. When, year after year, prices remained low, a new consensus emerged: conservation and increased production would quickly offset any increase of price. The era of cheap oil, in other words, would continue into the “foreseeable” future.

Read the full letter below.