Economic forecasters fail in constant refusal to learn from past

From a policy point of view, there are some useful rules of thumb that provide better guidance than most complex models. The Bank of England’s Andrew Haldane, one of the most thoughtful central bankers around, has written extensively about this and persuasively argues for the adoption of simple but robust tools and techniques that, among other things, embody learning.

From a policy point of view, there are some useful rules of thumb that provide better guidance than most complex models. The Bank of England’s Andrew Haldane, one of the most thoughtful central bankers around, has written extensively about this and persuasively argues for the adoption of simple but robust tools and techniques that, among other things, embody learning.

 

Back in 2008, the queen of England famously asked a group of economists why they didn’t see the financial crisis coming. It took them nearly eight months to formulate a reply. Their answer stated she was quite right to ask the question. I think this was wrong; the question missed an important point.

More reasonable to ask would have been: “In finance and economics, why can’t we consistently forecast anything?” Perhaps the only honest answer to any question about the future is this: “we don’t know”. The puzzle is why the queen seems to think that experts know something about what is likely to happen next. It is not exactly news that forecasting is tough.

Most forecasts are wrong, sometimes spectacularly so. When the euro was first introduced, I thought that that was the end of the exchange rate crises that had so bedevilled Europe. That bit of the forecast was right but I completely missed the (now) rather obvious point that financial crises can come in many forms, not just via the foreign exchanges. As the authors of the reply to the queen said, “most were convinced that banks knew what they were doing”.


Fundamental flaws
It seems that nobody can forecast. Ben Broadbent, of the Bank of England, is an example of a thoughtful economist who has explored just why this is so. Broadbent usefully points out the only reason stock prices and exchange rates change at all is because of forecasting errors. Any investment, in a sense, is a bet on somebody else’s forecasting mistake.

Forecasting is mostly a waste of time. Not because we are idiots but because finance is not physics: unlike the hard sciences, our tools, techniques and data are simply not up to the task of building accurate representations of how, in aggregate, the world works. We try, boy do we try.

Physics envy has led to sophisticated mathematical models of the financial world. But those models don’t work well, don’t capture what we have just lived through.

How to describe the mainstream approach? Consider this quote, taken from the International Monetary Fund website in a profile of one half of the now infamous Reinhart-Rogoff duo:

“[Reinhart] does not fit the mould of the typical academic economist, who spends much of his or her time exploring pointless extensions of the dominant paradigm.”

Think about that for a second. In dreaming of a glittering academic career, can we imagine anyone aspiring to spending their days over “pointless extensions of the dominant paradigm”? Yet this is how at least one very well-respected academic sees his own profession (there are plenty of others who are similar). And the puzzle is why this has not led to a fundamental rethink of how economists ply their trade.

The point is not that economists are fools. Typically, they are very smart (but occasionally prone to allowing ideology infect the maths). It is simply that what they are trying to do, particularly when it comes to forecasting, is so hard as to be next to impossible. It is quite wrong to berate them for forecasting mistakes. It’s the lack of learning from forecast errors that astonishes.


Future always uncertain
Yet we still ask the dumb question: “What will happen tomorrow?”

The smart question, “How can I best think about an uncertain future”, is rarely asked. Honourable attempts are being made to learn. But my sense is they are still the exception not the rule.

Paul Krugman is but one prominent critic bemused by the lack of learning in the face of models and their implied policies that have clearly failed – by forecasts that have been wrong.

Most obviously, austerity hasn’t delivered as forecast, yet few in authority seem too bothered by this.

From a policy point of view, there are some useful rules of thumb that provide better guidance than most complex models. The Bank of England’s Andrew Haldane, one of the most thoughtful central bankers around, has written extensively about this and persuasively argues for the adoption of simple but robust tools and techniques that, among other things, embody learning.

Right now, an obvious suggestion would be that if your policies are not working, try something else. Look at what is working elsewhere: in the US, they have sensible monetary policy, an absence of austerity (at least until the economy started to grow again). They have aggressively sorted out the banking system and a lot of personal debt has been written off. It’s a formula that seems to work.

Chris Johns is an online columnist in the business section of The Irish Times website: (iti.ms/13AqfPT)