Economists failed to foresee the last recession and, given the scale and reach of the crisis, they have been trying to live that failure down ever since. Not only did they not see it coming, they disagreed on how to get through it, and today seem no better equipped to anticipate a future financial crisis.
Their economic models were also caught out by the oil price crash, and the collapse in Chinese demand last year, global events that have a huge impact for global businesses. It does seem that while their models are of limited value in times of stability, they fall apart when they are needed the most, during times of uncertainty. And with the EU referendum looming, some certainty over what an “In” or “Out” result will have on Britain’s future is what’s needed right now.
Economics is not a black and white science. We have to be realistic and acknowledge that economic forecasting is difficult at best; human behaviour is fickle and forever changing and the global economy is complex and unpredictable. Even the former chief economist at the World Bank, Joseph Stiglitz, has said that economists only get it right at best around three or four times out of 10.
And as Joseph Lake, director of global forecasting at The Economist Intelligence Unit in New York, points out, no matter how good their models become, economists will not be able to predict the future perfectly. “That does not make economists useless, but they are more useful if you are aware of the inherent shortcomings,” he says.
He likens it to being the coach of a top sports team; you know that if you put out a team full of superstars who have performed well together in the past (an economist with the most robust models that performed well historically), that does not guarantee they will win (or that the model will accurately predict the future), but you can be more confident in them than the alternative options.
Experience also shows that the further in the future economic models try to predict, the greater the risk of an inaccurate prediction.
Lake says: “A good analogy I’ve heard is that economists should be treated like doctors; you would not always expect your doctor to predict when you fall ill, but you would expect some good advice about how to avoid becoming ill and instructions on what to do if it happens.”
Jeremy Cook, chief economist at World First foreign exchange insists that asking economists to predict the future with precision is asking for trouble. He says: “What we are able to do is assign a probability to a future event taking place based on mathematical modelling and history. That’s the science part. The art comes when the need arises to view those results through a prism of psychology, geography and social dynamics.
“In my line of economics, global currency markets, there is an endless list of factors that could impact economic events. The world moves fast, too fast for any human mind to predict, but with the right training economists can get pretty close more often than not.”
Predictions are notorious for being wrong, and economists are certainly not on their own in having made mistakes, so accuracy in forecasting is no yardstick of their value or influence. Professor Sir Keith Burnett, vice chancellor of the University of Sheffield, argues that in assessing the importance of the economist’s role, we need to acknowledge that there are those who are very important in identifying issues and trends beyond the better-known “schools of thought” within economics.
He says: “Jeremy Grantham is a superb fund manager, which he combines with a profound concern for the impact of climate change and the many reasons economists and financiers fail to take action to correct a major global concern. He is an almost prophetic figure.
“Andy Haldane at the Bank of England explains eloquently the impact of short term thinking and the loss of institutions capable of working beyond the constraints of quarterly shareholder returns. I admire these people for honing in on long-term questions and grappling with how to address them.”
Elsewhere, however, the views on the value of economists and their models and forecasts are divided. Some see a good economist as someone who can bring clarity and foresight to a situation; others say that economists can be a liability.
According to Ian Cass, managing director of the Forum of Private Business, the rise in the national living wage is a great example of the latter.
He says: “This is an economist’s solution to an economy working close to capacity but needing to improve productivity. However, a bit of common sense would have highlighted the need to prioritise small employers enrolling their staff in pensions and improving productivity by motivating business owners by reductions in tax and freedom from red tape.”
According to Lake, decision-makers should use economic models to get a better sense of what to expect in the future, and should be looking at the upside and downside risks to these forecasts, and also have contingency plans in place to deal with those. He says: “There are of course some areas in which economists are better at forecasting than others; the oil price and currency markets remain difficult due to the sheer scale of factors, and the imperfect information available, but economists have a good track record in other areas.”
While many decision makers and business leaders do heed Lake’s advice, others refuse to be influenced by economic predictions. Jake Willis is co-founder of shared accommodation firm London Shared, a business that was launched in 2007, just as the rumblings of an economic crisis were starting to emerge.
He says: “We didn’t know what was going to happen, but we didn’t pay that much attention to what the economists were saying. In spite of the recession that followed, everything worked out really well for us. As a business owner, you do listen to the economic forecasts, but you also have to go with your gut instinct. And those forecasts are not a major part of our decision-making.”
Then there are the stock markets. With the current sell-off in the market, investor confidence has been shaken in the underlying strength of the UK and global economies. However, many argue that the FTSE 100 is a poor proxy for the strength of the UK economy, being dominated by natural resources companies, banks and pharmaceuticals.
There could even be an argument to say that the whole of the listed markets are a poor proxy for the health of the UK economy, as employment growth since the recession has largely been powered by the unlisted small and medium-sized businesses.
As an investor in mid-sized growth businesses in the UK, Charlie Johnstone, head of origination and partner at private equity group ECI Partners, believes that air time and credence given by economists to large swings in the listed markets as an indicator of the health of the UK economy or extrapolated to forecast future trends is often unhelpful. He also frequently sees a very different story on the ground to that predicated by economists and academics.
He says: “Yes, there are certain sectors directly affected by economic and market factors, such as low oil prices for example, but most of the mid-sized businesses we speak to about investment have been unaffected by the drop in the oil price, or in some cases received some marginal cost benefit. Our portfolio companies give us a useful insight into what is actually happening, not just models and forecasts.
Graham Glover, director of financial management firm Johnston Campbell, takes a pragmatic view of economic forecasting, as all the macro and micro analysis in the world still seems incapable of catching the dramatically shifting reality within the capitalist economies.
He says: “Perhaps this is a great time to be an economist precisely because classical thinking won’t be enough, looking ahead. Perhaps there’s as much behavioural psychology as there is mathematics to forecasting successfully in the future, and the information and new models economists use to predict the future will develop and change. In the meantime, in my world of investment, I still require excellent information and analysis from different sources to help my team decide if assets, at this most volatile time, are trading at the right prices.”
BENEFIT OF HINDSIGHT
But what about the bigger picture and the events that have had a major impact on the world economy; surely economists should be better prepared for these? Hindsight is 20/20 vision, and as Professor Burnett points out, a perpetual problem in our understanding of economics is a stereotype of what it means to have a planned economy or free market solution.
He says: “I have been re-reading what Hayek said about the dispersion of knowledge and what Keynes said about planning and I think both have been badly misrepresented into an either/or approach which does us considerable harm.
“We also inevitably look at things in the light of our own economists and histories in ways that make little sense in India or China. If we think
of China, its approach to a planned economy or capitalism with a Chinese face is long term, not subject to the electoral cycle, and informed by a history in which the key challenge was to feed a great population. If we don’t understand these things, we will never understand the driving forces in our world.”
Against a backdrop of increasing global uncertainty and unpredictability, does this mean that economists are struggling to remain influential? Lake believes not. He says: “The reputation of economists was damaged by the financial crisis, which few economists saw coming. However, economists are still relied upon by governments and businesses to create realistic projections of future activity. This is especially important in times of global uncertainty. It is an imperfect profession, but economists provide valuable information that can help policymakers and companies make strategic decisions.”
Another important aspect is that economists should make clear the assumptions they make in their models, and their own biases, so that people using the forecast have full transparency.
“How they decide on the forecast may be even more important to the user than the forecast itself, and give them clarity on how careful they should be in using the results,” says Lake.
When economists get their predictions wrong, they need to learn, like anyone else. Economists are human, they are fallible, but their job is to identify the underlying trends and to prevent economic crises from recurring. After 2008 it became clear that economists are not the only ones who get things wrong and also that there is more to a country’s economic prosperity than economic modelling and market predictions.
Professor Burnett says: “Jim O’Neill has said that were he to come up with the concept of ‘BRICs’ today, he would have used a different acronym: ‘C’. Does that undermine the concept’s value? Not at all. As an idea, BRICs continues to get people excited about exporting to emerging markets and has inspired a generation of start-ups and entrepreneurs to identify new markets that benefit their own businesses. That’s economic modelling at its finest.”
Economics is absolutely relevant, but it is being challenged, and rightly so. The global recession simply posed new questions, and overturned old assumptions. But what are the repercussions for economists when they get it wrong? The incentive and risk is the economist’s reputation, says Lake, and over time, economists who make more accurate forecasts should, all else being equal, be rewarded with better reputations, and receive the professional rewards associated with that.
He adds: “The danger is that people are more inclined to remember predictions of negative events than positive ones. So, for instance, there is little incentive to correctly forecast several years of steady expansion in the US economy, as it attracts few headlines, but if you correctly predict a recession, then your standing is boosted measurably."