The Failure of Forecasting by Analogy

Editor's note: This is a special bonus column for TheStreet.com readers. Anirvan Banerji's column appeared Oct. 31 on RealMoney.com. To sign up for RealMoney, where you can read his commentary first, please click here for a free trial.

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In the early summer, I highlighted the structural shift in manufacturing jobs, which account for 90% of U.S. job losses since the recession began. Back then, it was a fresh -- and controversial -- insight, on the basis of which I predicted a lopsided recovery, more in GDP, less in jobs. Today, it's not just a well-known fact; it's a hot-button political issue.

Growth in the Economic Cycle Research Institute's Weekly Leading Index soared to a 20-year high in the summer, raising many eyebrows. Three months later, GDP growth has rocketed up to a 19 1/2-year high, raising fewer eyebrows because the earlier pessimism has largely waned.

The Red Queen Effect

Back in the summer, the ruling consensus held that this was a jobless recovery like the one in 1991-92, and strong job growth would show up once GDP growth increased. But the structural shift is rooted in firms' lack of pricing power, forcing them to cut costs by boosting productivity and outsourcing jobs overseas -- a dynamic that's still unchanged. Therefore, while job growth will surely improve as GDP growth ramps up, it will have to contend with the structural headwinds impeding job creation -- what one might call the Red Queen Effect.

As the Red Queen in Looking Glass Land tells Alice, "Now, here, you see, it takes all the running you can do to stay in the same place. If you want to get somewhere else, you must run at least twice as fast." What policymakers are therefore trying to do is to make the economy run twice as fast, and that will indeed help job creation. But because of the Red Queen effect, job growth still won't match GDP growth.

Why did so many analysts fail to realize that a structural shift was under way? Why did they fall en masse for the analogy with the 1991-92 recovery, missing what was truly different about this cycle? The answer has a lot to do with many analysts' basic approach to forecasting.