First published Research World October 2009

Jo Bowman

Forecasting global markets relies as much on real-world people-watching as it does on number-crunching, Deutsche Bank group chief economist Norbert Walter tells Jo Bowman.

Given that the greatest economic collapse for more than 50 years took much of the world by surprise, you might expect the chief economist of a major bank to begin his reflections on the past year with an apology. Deutsche Bank’s Norbert Walter does not disappoint.

“We misguided the world … we were not humble enough,” he says of economic researchers. He says financial institutions took on business that carried a far greater risk than they understood or were prepared for, often based on research that they took at face value.

“We made customers believe that we could predict the future; they relied completely on us,” Walter says. “Economics is a social science with expectations about human behaviour. Therefore, it is difficult to take forecasts at face value. One should always keep in mind that we are not physicists who are able to calculate future actions of human beings as exactly as the earth’s gravity.”

Walter puts the blame for ‘critical mistakes’ in the lead-up to the crisis at the door of regulators and politicians, who he says ignored dangerous developments in financial markets. “As opposed to researchers, they had access to information about financial flows and the power to restrain this behaviour,” he says. “Light-touch regulation was a false promise for a better world. It created the casino that now has collapsed. Information has to be more transparent for all economic agents, especially when it comes to sophisticated assets. Incentives for economic agents must be reoriented to the longer term and the interest of the customer.”

Super models
How might the signs of instability be read more accurately in future? One important indicator of the impending doom, Walter says, was the growth in the availability of credit, particularly in the US, but also in some European countries, that led to bubbles in property markets, in commodities and in stock markets; it was inevitable that the bubbles would, sooner or later, go pop.

“These developments were made possible by loose monetary policy with low interest rates, leading to ever increasing incentives to invest in risky assets,” Walter says. “Central banks were too much focused on goods price inflation, neglecting developments on real estate and stock markets.”

One might have thought that econometric modelling was supposed to track all of this. So, was the error with the modelling, the data on which it was based, or the way in which it was interpreted? Walter explains: “The measurement of predicting human behaviour has changed during recent years. Whereas adaptive behaviour has been modelled in the past, researchers today base their forecasts on rational expectations of economic agents (that is, people). Nevertheless, they could not have prevented the crisis, partly because it was rational for the individual to stay in the market as long as his neighbours were still making profits.

“The crisis was not due to misinterpretation of human behaviour, but to inappropriate incentive systems, not avoiding conflicts of interest, such as securities-issuing houses paying for the services of rating agencies.” That said, Walter concedes that some financial engineering took too narrow a focus, developing theories and informing decisions based on single observations.

Risk seems to have been particularly badly assessed, and on this, Walter says too many banks accepted too high a level of risk simply because everyone else was doing it. “The risk management in many banks was insufficient; liquidity concerns were underrated,” he says. “This was not only due to measurement error, but also to management failure. Herding behaviour has been one major symptom that led to the creation and distribution of so-called toxic assets. Loose financial supervision and creative accounting procedures boosted this development.”

The information on which assumptions were based was also lacking, Walter says. He urges the makers of monetary policy to include asset market inflation in their analysis in future.

“We’ve seen that a revised strategy will be needed to capture not only goods price inflation but also asset price inflation. There is also the fact that we all live in a world with free capital and goods flows and very fast flows of information. Consequently, we will need more international co-ordination in forthcoming years to continue to benefit from free global trade.”

Quantitative easing
If crucial economic indicators were missed, badly read or ignored by so many of the world’s most powerful people and institutions, what has happened to the credibility of information?

Walter says that logic and numbers have lost some of their lustre. “During the financial crisis and the ensuing worldwide recession, the reputation of forecasting has suffered a blow,” he says. “Belief in quantitative models has been especially shaken. Some economists claim that this profession does only allow qualitative analysis.

“I believe that quants indeed have overdone it; they often left customers to believe they could reliably predict the future. This has been shaken. But qualitative economists often underestimate the role and competency of empirical research, based on hard and soft data. Qualitative economists should learn econometrics, and quants should study game theory and volatility of human behaviour to improve their research.”

What hasn’t happened, Walter insists, is that economics as a whole has suffered too great a blow to its reputation.

Certainly public interest in economics has, if anything, been enhanced by recent events, with titles such as Steven Levitt’s Freakonomics and Tim Harford’s The Undercover Economist global bestsellers.

“The importance of economic advice has increased significantly since the start of the crisis,” Walter says. Deutsche Bank is a leading global investment bank employing more than 78,000 people in 72 countries. “In my position as chief economist, I have even more requests for expertise than before. Our profession has learned new lessons about the behaviour of agents, especially in a globalised world. Hopefully, politicians will be able to learn from the crisis as well.”

New world order
If the slide of national economies deeper into recession has been stopped, this should not be taken as an indicator that happy days are near again, Walter warns.

“The world now, in the third quarter, looks as if it’s on its way back into recovery and you’ll hear many market analysts tell you ‘we’ve done it, it’s over’. I disagree. This is a temporary relief to do with the effects of (governments’) stimulative measures; it’s not the beginning of an endogenous upswing.” The end of the year will see more jobs lost in developed markets, low wage increases, and sluggish consumer spending, and the outlook for next year is little better. “Only in 2011 do I expect that the world will be on recovery path,” Walter says.

New economic powerhouses will come from Asia with growth engines like China, India and smaller East Asian countries such as Indonesia and Vietnam.  Growth in the US, which was an ‘excessive’ 3.75% in 2007, will be closer to 2% in 2011, and Spain, where there’s been a painful property market crash after economic growth of 4% in 2007, will only manage 1% when recovery comes. In India, meanwhile, Walter expects growth to continue at about 7%, and Indonesia to stay strong at about 5%. Some of these markets are facing other social and economic pressures, as the preference for boys over girls in China and India has led to a highly skewed birth rate that’s produced millions of young men with no hope of finding a partner. Walter says that there are currently 127 men for every 100 women in China, and 116 for every 100 in India.

The interconnectedness of disparate economies has become patently clear during the struggles of the past year. Regional and global regulations – and international supervision of them – are needed now.

Walter says: “The success of implementing new rules for the financial system simply relies on the ability of nation states to learn from their mistakes – and this applies to private agents, supervisors and regulators – and particularly to find common solutions on an international level.”

There are lessons too for economists and for market researchers, Walter says, not least from each other. “Theoretical innovations in research divisions are in many respects helpful to adjust the econometric models of economists,” he says. “On the other side, researchers often find new hypotheses by analysing empirical results of researchers. I believe that both disciplines rely on each other and will not survive without the support (for each other).”

Walter cautions that no matter how good the information on which economists rely, and how sensitive are the models used to forecast activity, economics can never be infallible. He says: “Economics is about human behaviour, which is still unpredictable – even for economists.”

As chief economist of Deutsche Bank Group, Norbert Walter is responsible for a globally integrated approach to economic research as well as managing Deutsche Bank’s think tank. He is a member of the board of directors of the American Chamber of Commerce and a member of the Council of Reutlingen University.

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