Jiacheng Xiao looks at the role of an economist and discusses a constantly asked question: Why are economists so often wrong about the future?
If you have been reading the news recently, you may have seen articles criticising the work of economists. There seems to be a constant debate about whether economics should be classed as a science or not. Such voices are particularly strong when there is a recession, which economists often fail to predict. So, why does this occur? Unfortunately, when people treat predictions made by economists as ‘weather forecasts’ and rely on them, they are often disappointed because economists appear to be quite bad at predicting the future. Recently the Chief Economist of the Bank of England, Andy Haldane, admitted that incorrect economic forecasts have brought economists’ reputations into question. When a weatherman get the forecast wrong, the consequences are usually trivial. For example, you decide to wear a t-shirt when it’s freezing cold, you don’t bring an umbrella when it rains, or you have to play football in a storm. But if economists get it wrong, the consequences are much worse. People make investment decisions that can turn out to be unprofitable if economic conditions differ from the forecasts, which can affect many people’s livelihoods. So why do economists get things wrong about the future?
WHY ECONOMISTS ARE OFTEN WRONG
Let’s start with a simple example using only basic knowledge of economics: supply and demand. Assume people believe economists and think that their predictions are reliable. Then if economists predict that the price of wheat will go up next year, farmers will want to take advantage of this. As a consequence, farmers will plant more wheat and, come harvest time, the supply of wheat will increase. If the demand for wheat does not change, the increase in its supply will cause the price of wheat to fall, not rise. Therefore, it appears to the public that the economist’s prediction was incorrect. The problem here is that the prediction actually changes people’s behaviour. So, why don’t economists take this into account when making their forecast? Well, they do – this is why economists now use ‘microfoundations’ – or build up their forecasts by looking at individual decisions. The idea is to capture the rules of individual behaviour that don’t change when outside circumstances – like forecasts – do. The difficulty in practice with this approach is that there are infinitely many factors which influence decision making. In the real world, economists rarely know the rules of individual behaviour. One recent example, reported in the Wall Street Journal, is that billionaire investor George Soros lost nearly $1 billion in the weeks after the election of Trump. Economists predicted that, due to uncertainty about the future, the US stock market would fall after Trump’s election since people should sell stocks and buy gold in order to avoid risks. However, the stock market turned out to be spurred. Unlike the weather, which follows certain immutable rules, people’s behavior changes constantly hence making economists wrong when they make predictions based on what people used to do. In general, it is uncertainty of people’s behaviour which makes the economist a bad weatherman.
So what drives people’s behavior and decision making? It is their cognition. People make their decisions, for example about which stock to buy, by thinking about all information they have. A cognitive bias is a type of systematic error in thinking that occurs when people are processing and interpreting information. When making statements and predictions, economists tended to ignore the effects of individuals’ cognitive biases. Economists assumed that on average, those under- or overestimating the market should roughly cancel each other out. Nowadays, as behavioral finance and economics have developed, scholars have started to realise the importance of cognitive biases. If these biases can significantly interact with, or affect the market, then economists may fail to predict the market outcome because it is almost impossible to account for all cognitive biases among market participants. For example, when bad news comes and a company’s stock price is falls, some people may think that it is a good time to buy this stock while the others may think they should sell it, hence making the market outcome ambiguous.
ECONOMISTS’ WORLD V.S. THE REAL WORLD
The world is complicated, and there are too many factors to account for. In order to make useful statements and predictions, economists always make unrealistic assumptions to simplify the problems. But how unrealistic are these assumptions, or, how far away is the economist’s world from the real world?
Here are some examples to light the way. Economists always build their model based on the assumption that people are rational. This is an essential assumption because we can only know how people will behave if they are rational — they will make optimal decisions to maximize their own wellbeing. You can’t tell what kind of choice a person will make if they are irrational, and this is exactly the problem: One has to assume that people are rational in order to let the model works, but in the real world people are likely to be irrational, in that they often make decisions that may not increase their happiness. Also, economists always have to assume that people have utility functions – or a mathematical formula that describes their happiness – and that they make decisions based on the calculation of their lifetime utility. But is it believable that people are able to constantly reevaluate such a calculation in their head in real world? Moreover, financial theory dictates that a company’s stock price should be equal to its intrinsic value – this is the value of all its expected future returns – but in the real world it is hard to calculate a company’s intrinsic value. Even if it can be calculated – how many people will actually do that? Last but not least, in macroeconomics, models are built based on the assumptions that, for example, there are only two countries, there is no population growth, and capital can flow from one country to another, and so on. All of these assumptions are unrealistic. Economists apply these assumptions because they do simplify things a lot and make it possible to build models. However, since these assumptions are unrealistic, the world economists build is segregated from the real world. In general, it is impossible for economists to build a model that fully captures the real world.
DO ECONOMISTS KNOW THAT THEY ARE WRONG?
I still remember my first lesson from my supervisor, Professor Sevi. He said “in economics, we know that our models are always wrong. We build our model, bearing in mind that it is wrong, to see how much it can explain the real world”. You see, economists do know that they are often wrong. In fact, treating economists as weathermen is not appropriate. What a weatherman does is to try to forecast the future, but for economists, their major job is to help us learn from the past. Economists are trying their best to summarise and explain what has happened in the past, or, what’s happening right now, and use these precious experiences as a guide for our future. Yes, economists may never get it right about exactly when a financial crisis will happen, but what they are trying to do is to learn from past crises, finding out what leads to these crises and what we may be able to do to avoid them in the future. It’s not about predicting the future, it’s about how to get to a better future. Your future remains uncertain, but there are lights to guide you, so that you don’t get lost.