{"id":172285,"date":"2023-03-12T20:37:00","date_gmt":"2023-03-12T20:37:00","guid":{"rendered":"https:\/\/precoinnews.com\/?p=172285"},"modified":"2023-03-12T20:37:00","modified_gmt":"2023-03-12T20:37:00","slug":"why-economists-keep-getting-it-wrong-but-never-stop-doing-their-sums","status":"publish","type":"post","link":"https:\/\/precoinnews.com\/economy\/why-economists-keep-getting-it-wrong-but-never-stop-doing-their-sums\/","title":{"rendered":"Why economists keep getting it wrong, but never stop doing their sums"},"content":{"rendered":"

Why are economists\u2019 forecasts so often wrong, and why do they so often fail to see the freight train heading our way? Short answer: because economists don\u2019t know as much about how the economy works as they like to think they do \u2013 and as they like us<\/em> to think they do.<\/p>\n

What happens next in the economy is hard to predict because the economy is a beehive of humans running around doing different things for different reasons, and it\u2019s hard to predict which way they\u2019ll run.<\/p>\n

<\/p>\n

The Reserve Bank is far more prone to admitting the fallibility of its modelling exercises than most modellers.<\/span>Credit:<\/span>Peter Braig<\/cite><\/p>\n

It\u2019s true we\u2019re subject to herd behaviour, but it\u2019s devilishly hard to predict when the herd will turn. Humans are also prone to fads and fashions and joining bandwagons \u2013 a truth straightlaced economists prefer to assume away.<\/p>\n

I think it embarrasses economists that their discipline\u2019s a social science, not a hard science. Their basic model of how the economy works became entrenched long before other social sciences \u2013 notably, psychology \u2013 had got very far.<\/p>\n

They dealt with the human problem by assuming it away. Let\u2019s assume everyone always acts in a rational, calculating way to advance their self-interest. Problem solved. And then you wonder why your predictions of what \u201ceconomic agents\u201d will do next are so often astray.<\/p>\n

Actually, the economists don\u2019t wonder why they\u2019re so often wrong \u2013 we do. They prefer not to think about it. Anyway, there\u2019s this month\u2019s round of forecasts we need to get on with.<\/p>\n

The economists\u2019 great mission over the past 80 years has been to make economics more \u201crigorous\u201d \u2013 more like physics \u2013 by expressing economic relationships in equations rather than diagrams or words.<\/p>\n

These days, you don\u2019t get far in economics unless you\u2019re good at maths. And the better you are at it, the further up the tree you get. The academic profession is dominated by those best at maths.<\/p>\n

Trouble is, although using maths can ensure that every conclusion you draw from your assumptions is rigorously logical, you\u2019ll still get wrong answers if your assumptions are unrealistic.<\/p>\n

In the latest issue of the International Monetary Fund\u2019s magazine, the ripping read named Finance and Development<\/em>, a former governor of the Bank of Japan reminds his peers about the embarrassing time in 2008, after the global financial crisis had turned into the great recession, when Queen Elizabeth, visiting the London School of Economics, asked the wise ones why none of them had seen it coming.<\/p>\n

With frankness uncharacteristic of the Japanese, the former governor observed that King Charles could go back and ask the same question: why did no one foresee that the economic managers\u2019 response to the pandemic would lead to our worst inflation outbreak in decades?<\/p>\n

One answer would be: because all our efforts to use computerised mathematical modelling to make our discipline more rigorous has done little to make us wiser. The paradox of econometric modelling is that, though only the very smart can do it, the economy they model is childishly primitive, like a stick-figure drawing.<\/p>\n

The best response some the world\u2019s economists came up with, long after the Queen had gone back to her palace, was that academic economists had largely stopped teaching economic history.<\/p>\n

These days, economists can\u2019t do anything much without sets of \u201cdata\u201d to run through their models. And before computerisation, there were precious few data sets. But those who forget history are condemned to . . .<\/p>\n

The great temptation economists face is the one faced by every occupation: to believe your own bulldust. To be so impressed by the wonderful model you\u2019ve built, and so familiar with the conclusions it leads you to, you forget all its limitations \u2013 all the debatable assumptions it\u2019s built on, and all the excluded variables it isn\u2019t.<\/p>\n

As part of the academic economists\u2019 campaign for an inquiry into the Reserve Bank, some genius estimated that the Reserve\u2019s reluctance to cut its already exceptionally low official interest rate even lower in the years before the pandemic had caused employment to be 250,000 less than it could have been.<\/p>\n

Only someone mesmerised by their model could believe something so implausible. Someone who, now they\u2019ve got a model, can happily turn off their overtaxed brain. There\u2019s no simple linear, immutable relationship between the level of interest rates and the strength of economic growth and the demand for labour.<\/p>\n

At the time, it was obvious to anyone turning their head away from the screen to look out the window that, with households already loaded with debt, cutting rates a little lower wouldn\u2019t induce them to rush out and load up with more \u2013 the exception being first-home buyers with access to the Bank of Mum and Dad, who as yet only aspired to be loaded up.<\/p>\n

To be fair to the Reserve in this open season for criticism, it\u2019s far more prone to admitting the fallibility of its modelling exercises than most modellers are \u2013 especially those \u201cindependent consultants\u201d selling their services to vested interests trying to pressure the government.<\/p>\n

In its latest statement on monetary policy, the Reserve explains how its modelling finds that supply side factors explain about half the rise in the consumer price index over the year to September 2022.<\/p>\n

But then it used a more sophisticated \u201cdynamic stochastic general equilibrium model\u201d which found that supply factors accounted for about three-quarters of the pick-up in inflation.<\/p>\n

The Reserve\u2019s assistant governor (economic), Dr Luci Ellis, told a parliamentary committee last month that this \u201ctriangulation\u201d left her very confident that the demand side accounted for at least a quarter and probably up to a third of the inflation we\u2019ve seen.<\/p>\n

(Remembering the debate about the extent to which the present inflation surge reflects businesses sneaking up their profit margins \u2013 their \u201cmark-ups,\u201d in econospeak \u2013 note that this second model includes \u201cmark-up\u201d as part of the supply side\u2019s three-quarters. Always pays to read the footnotes.)<\/p>\n

One of the tricks to economics is that many of the economic concepts central to the way economists think are \u201cunobserved\u201d \u2013 the official statisticians can\u2019t measure them directly. So you need to produce a model to estimate their size.<\/p>\n

A case in point is the economists\u2019 supposed measure of full employment, the NAIRU \u2013 non-accelerating-inflation rate of unemployment \u2013 the lowest the rate of unemployment can fall to before this causes wage and price inflation to take off.<\/p>\n

Some of those business economists who believe the Reserve hasn\u2019t raised interest rates nearly enough to get inflation down justify this judgement by saying our present unemployment rate of 3.7 per cent is way, way below what conventional modelling tells us the NAIRU is: about 5 per cent.<\/p>\n

But Ellis told the parliamentary committee that the Reserve had rejected this estimate. The \u201cstaff view\u201d was that the NAIRU had moved from \u201cthe high threes to the low fours\u201d, and this was what its forecasts were based on.<\/p>\n

So why dismiss the conventional model? Because, Ellis explained, it\u2019s driven solely by demand-side factors. It\u2019s \u201cnot designed to handle the supply shocks that we have seen over COVID\u201d.<\/p>\n

Oh. Really. Didn\u2019t think of that. Mustn\u2019t have had my brain turned on.<\/p>\n

Ross <\/i><\/b>Gittins<\/i><\/b> unpacks the economy in an exclusive subscriber-only <\/i><\/b>newsletter<\/i><\/b> every Tuesday evening. Sign up to receive it here.<\/i><\/b><\/p>\n

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