When economic forecasting goes horribly wrong
Between 2001 and 2006, renowned economist Lawrence Summers, winner of the 1993 John Bates Clark Medal, and then president of Harvard University, entered into a series of forward swap contracts with Goldman Sachs, JPMorgan, and other big banks — contracts that eventually cost the university an estimated $1 billion.
Why it matters: Summers' macro forecast turned out to be very wrong. He thought that interest rates were low and sure to rise; in reality, after the financial crisis of 2008, we entered a period of ultra-low interest rates from which we are only now emerging.
- The financial crisis forced Summers to scrap his plans to build a huge new science complex. According to those plans, Harvard would have to borrow floating-rate debt as far out as 2022; Summers seem to have been trying to make sure Harvard could swap that debt into a low fixed-rate obligation.
- As early as 2006, Moody's was warning that the bets were very risky. They were right: When the construction plans were scrapped, Harvard took what Vanity Fair's Nina Munk described as "approximately a $1 billion unrealized loss from interest rate swaps."
The bottom line: The bets, which have been described as "rank hubris", are a very good reminder that when it comes to bets on interest rates and other economic phenomena, being very smart can work against you.