How can we forecast future trends in the global economy?

When statistical and mathematical methods were first being introduced in economics, Lawrence Klein showed up on stage. He became a leading figure in the new field of econometrics. Having witnessed the hardships of the Great Depression, he was eager to learn more about the essence of such crises. Over the course of his career, he created models that would accurately forecast economic trends, not only for the United States, but on a global scale. The Cold War was still dominating international affairs, but Klein talked to scientists in socialist countries to find out how important issues in the world economy could be addressed.

Lawrence R. Klein

Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 1980

At a glance

Born: 1920, Omaha, Nebraska, USA

Died: 2013, Gladwyne, Pennsylvania, USA

Field: Macroeconomics

Prize-winning work: Creation of econometric models and their application to the analysis of economic fluctuations and economic policies

Hello, Mr. President: Coordinated Jimmy Carter’s economic task force in 1976, but turned down the invitation to join his administration

An ‘un-American activity’: During the McCarthy era, Klein was denied tenure at the University of Michigan because he’d briefly been a member of the Communist Party

A desire to understand the world

In the 1930s, many young Americans decided to study economics to understand why crises such as the Great Depression occurred – and so did Klein. “I wanted to understand why the world was having such great problems,” he explained. When he took up his studies, his advisors wondered why he took so many mathematics courses. But he didn’t pay any attention to them. “I kept doing what I did, and I was able to piece together the connection between mathematics and economics in a very simple way.”

When he got his first degree from the University of California in 1942, Klein began to specialize in what was then the new science of econometrics. He wanted to practice economics in a way that would help solve real-world problems, so he started analyzing economic fluctuations to find out how the macroeconomy worked as a whole.

How can we answer what-if questions in economics?

Obviously, one can’t know everything about a complicated country with several million people making decisions all the time, so we have to make approximations.

That’s exactly what Klein tried to do with the models he built. “We have equation systems, and we find prices and interest rates that satisfy those equations. We take account of the restrictions that are imposed by the regulatory authorities, and we try to project the growth path of the economy.”

With his models, Klein not only developed ways of representing an economy, but he could also predict how it would be affected by future policy changes, for example in monetary and fiscal or international trade policy. “It’s inevitable that there will be some unexplained part, and our objective has been to make this part as random as possible. We can ask - how would the economy look if it was hit by random events or bad judgments?”

Using econometrics to challenge conventional beliefs

While the United States was still fighting in World War II, Klein was asked to model the economic situation of the country in the post-war period. People believed that the economy would sink into depression, but Klein and his research team at the University of Chicago used their models to show that this wouldn’t happen, as there was a demand for consumer goods that had been left unsatisfied because of the war, and there were lots of soldiers coming back home, which would also increase demand.

“Our results showed that the economy would be quite strong,” Klein remembered. “There would be a good basis for realizing what we called the pent-up demand by consumers.” Klein’s predictions were correct, and it wasn’t the only time he was able to prove the accuracy of econometric forecasting. Klein was also right later when correctly predicting what the economic situation would be after the Korean and Vietnamese Wars.

People feared that after the peace settlement, there would be a return to the recession we had in the 1930s, but we used our models to show that there wouldn’t be that kind of setback.

How can an economy maintain total demand?

Klein never left his academic position (despite the job offer from Jimmy Carter after winning the presidency in 1977), but he frequently commented on US politics. When the shift from military to civilian production was a hot topic of debate, he publicly claimed that if the government followed proper economic policies, demand in the economy could be maintained.

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“Military goods are not designed to produce the future income stream,” he explained. Klein was sure that neither the NATO – nor the Warsaw Pact – countries would suffer greatly from the shift to civilian production, and that unemployment wouldn’t increase if people allowed for a few years of conversion. Again, he based his assumptions on his own, as well as international modeling.

From hand-based calculations to automation

When Klein began his work, data-intensive analyses were still done laboriously by hand. Automating processes using machines wasn’t possible then, and wouldn’t be until the mid-1950s.

When the first computers came, Klein was there, using them to work with the large amount of data he needed. “Today, we make our calculations over and over again in the same day, in a few minutes, very fast. Computers have enabled us to explore the possibilities of economic life in much greater detail and over a much wider spectrum.”

Using this new technology, Klein was able to build his Wharton Econometric Forecasting Model, which focused on the development of the American economy. It contained more than a thousand equations to forecast economic fluctuations and business conditions, and to study the effect of changes in taxation and public expenditure.

Understanding how economies affect each other

But Klein wouldn’t spend his research activity concentrating on the US alone. “I shifted my main interest from a purely national to an international focus,” he explained. “We used to think of America as a closed economy, but it became much more open towards the end of the 1960s.” Klein understood that it wasn’t possible to really study the US economy without a very careful study of the world economy.

He became part of LINK, an international research project starting in the late 1960s. Under Klein’s leadership, the project was able to produce the world’s first global econometric model, by coordinating research from different countries across the globe. Scientists hoped that coordination would enable them to analyze how changes in the economy of one country would affect other countries. Today, LINK is maintained at the United Nations and includes almost 80 countries.

A model of centrally planned economies

LINK was a good example of how Klein cared about intensifying an international academic dialogue. Though he was criticized for spending time and effort on the Socialist countries, he established contacts with econometricians in Poland, Czechoslovakia and China, and began modeling centrally-planned economies.

Especially when China started its economic reform policies in the 1970s, Klein maintained a scholarly dialogue, discussing how to help the economy grow with his Chinese colleagues. Klein also used his econometric models to analyze the economies of Mexico, Japan, and Israel. And his international focus had another very pleasant side effect: over the course of his career Klein traveled regularly, giving him a great opportunity to see the world.

Why an economist can’t expect to be right all the time

While his econometric models had proven successful, Klein admitted that there was considerable room for improvement. As data processing became easier, he started working intensively in the area of high-frequency forecasting. “With fast computers, we can make very quick projections and stay in touch with the evolving situation.”

But Klein knew econometricians would never achieve perfection.

There’s so much economic noise in the world that when dealing with human behavior, the economist cannot scientifically expect to be right more than two-thirds of the time. We all operate in a system of probability and error.

But he didn’t give himself a hard time over this. He compared himself to a meteorologist, whose weather forecasts won’t ever be one hundred percent accurate. “My own feeling is that while I made some mistakes, the success rate has been very good to overbalance the mistakes.” (Klein, for example, once assumed Japanese cars wouldn’t be able to compete with American ones.)

Klein was awarded the Nobel Prize in Economic Sciences in 1980 for his econometric models and their ability to predict global economic trends. In the citation, the Nobel Committee emphasized how Klein had stimulated research on forecasting models unlike anybody else at the time. Thanks to his extensive research, econometric model building became a crucial part of economics, and was widely used. The Nobel Committee commented:

Few, if any, research workers in the empirical field of economic science have had so many successors and such a large impact as Lawrence Klein.

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