The desire to know the future is a deep psychic that human needs and it has been exploited by oracles and fortune tellers from ancient times. Also, it is obvious that knowing future can help to get many benefits, including material ones. Sherden gives some examples: ”making instant millions on Wall Street would be a piece of cake if you knew whether the economy was going to expand or contrast at a particular time or which technologies were going to become commercial successes. If you knew that a spate of unusually bad earthquakes or hurricanes was going to strike, you could short-sell property insurers for a handsome gain. You could make a killing in the commodities market if you could predict the climate for next year’s growing season” (Sherden 1998:1). So it is not surprising that the majority of forecasting professionals are working in money-related fields as investment advisers, marketing trend predictors, government policy decision advisers, to name the few. Today the predicting business is a multi-billion industry that employs hundreds of thousands of people. Although forecasting itself has always been a profitable activity, it is dangerous as well, especially, if forecasts are based on uncertain data or the methods used in forecast making are unreliable.
Economic and financial forecasting is a complicated, scientifically intensive and constant-expanding science, based on mathematical, statistical and econometric methods and theories. However, theoretic calculations that look sound on paper, often betray their creators in reality. Sherden mentions a widely-known joke that economists have forecast nine of the last five recessions. (Sherden 1998:55) This joke shows how inaccurate forecasts can be and gives a reason to ask another question – how much rationality is there in financial and economic forecasts? Keane and Runkle tried to answer this question. Although their study is on corporate profits, not on economics forecasting overall, they provide some useful insights into this problem. They tested rationality of earnings per share forecasts made by individual stock analysts, and failed to reject the hypothesis of rationality. However, according to their results, rationality as such does not exists as long as two complications are taken into account: “(1) the correlation in a given period of analysts' forecast errors in predicting earnings for firms in the same industry and (2) discretionary asset write-downs which affect earnings but are intentionally ignored by analysts when they make earnings forecasts” (Keane, Runkle 1998:768). The authors mention that their results challenge earlier works by De Bondt and Thaler, by Abarbanell and Bernard, who found irrationality in analysts' forecasts.
Having in mind such controversial results, one more question arises – on the whole, is it possible to forecast economy at all? Can it really be put in models and formulas? Finally, does the behaviour of economy in the past is a fairly valid source to predict its future actions? These questions are especially relevant now, when it is obvious that the current crisis was forecast only by few economists, and the extent of the predicted recession was less than we experience at the moment. To answer them, Sherden reviewed the leading research on forecasting accuracy contained in twelve studies and published during the period of sixteen years (1979-1995). He summarized the results of his study and composed the general picture regarding economists’ ability to predict the future.
The first affirmation of this picture states that economists cannot predict the turning points in economy – and that raises serious questions about the value and meaning of forecasting (Sherden 1998:61). If this assumption that economic and financial forecasts are useless is correct, then works of millions of economics professionals that have been studying and working in this field are now worthless. Forecasting in a very big part of current economical theory, Sherden even equalises it with meteorology. Except that methods of meteorology do not arouse doubts to anyone. What is more, nobody cares if the prediction is wrong by one percent, but this affirmation declares that forecasters are not able to predict the biggest changes of economy, and this is really very important. After all, what we really need forecasting for is predicting these issues.
The second conclusion of Sherden tells that economic forecast accuracy drops with lead time – this is logical, and even could be accepted. But with the third conclusion, author strikes hard – he tells: “Economists’ forecasting skill on average is about as good as guessing (Sherden 1998:63). The most common prediction they give is that there will be no change – and this is what statistically will be correct most of the times. But we do not need forecasting for that.
All other findings of Sherden are derivatives of the mentioned ones: “There are no economic forecasters who consistently lead the pack in forecasting accuracy”, “There are no economic ideologies whose adherents produce consistently superior economic forecasts”, “No economic forecaster has demonstrated a consistently higher forecasting skill in predicting any particular economic statistic”, “Increased sophistication provides no improvement in economic forecast accuracy” (Sherden 1998:64-68). Are any more proofs needed that economy is unpredictable?
If economy is unpredictable, economic and financial forecasting is irrational. Therefore, a big part of economics science is nothing more than a soap bubble and all textbooks of economics should be re-written. This means the fall of the current economic orthodoxy. Although in the classical economic system several schools of economics science with different main ideas exist, they all agree on the theory of the general equilibrium. According this theory, national economy is inherently stable and all economic fluctuations are caused by external shocks, like oil embargoes. However, economy has its natural forces that dampen theses shocks and restore itself to the natural resting point – that is, equilibrium. This theory is based on the general idea of self-regulation of economy that was presented by the father of economics Adam Smith in his ”The Wealth of Nations”. He called it an invisible hand. This model, together with theories of demand and supply included, is the basis of economic theory as we know it. And corollary to it goes the affirmation that economy is predictable, because logically, if economy always seeks a point of equilibrium, it is surely possible to predict its future course.
But as Sherden demonstrated, historical data state conversely. Moreover, if economy is unpredictable, then Mr Smith was also wrong and modern economists need to re-invent the theory of economics. Economy is actually a social system, and, like other systems of its kind, is complex and unpredictable. Complexity of a system is a term, defined only decades ago. It refers to a phenomenon of order, emerging from the complex interactions among the components of the system, influenced by one or more simple guiding principles. Such structures arise and live by some kind of self-organization, so there still is some truth in the affirmations of Adam Smith, but generally, economy does not act in predictable ways. Unless economists improve their ability to understand and analyse economics in a new way, and provide accuracy in their forecasts, “the twentieth-century pseudoscience of economics will become a twenty-first-century museum piece” (Ormerod 1997:96).
It is obvious that fundaments of the current economic orthodoxy have failed and the system of economics now requires new approaches of understanding and analysing it. Many economists now will give a second chance for the works of Ormerod, who already in 1997 wrote his “The Death of Economics”. There he explained how human societies and economies really operate. According to Ormerod, a classical free-market economics has not been very helpful during the latter half of the 20th century in explaining and solving economic problems. Despite the high regard in which classical theories of economics are held throughout the world, most if not all economists cling to ossified orthodoxies that provide precious little perspective on an increasingly complex world (Ormerod 1997: 124). Reviewing the work of economic pioneers, Ormerod makes a persuasive case against classic economics and proves that over the years once-exciting theories or constructs gained the status of doctrine and in the meantime, economists became hooked on math and modelling. And society has paid a high price for their tendency to take a linear, mechanistic view of commerce and industry. Business cycles, government spending, inflation, and unemployment – all of them continue to confound policy makers and their principal advisors, the economists. The author tends to see economics not only as a machine, or a discipline but, broadly speaking, studies production, distribution, exchange, and consumption of goods and services. Ormerod forms a new view of the economy – more as an organism than a machine, and places it in larger political, social, and moral context.
In his other work “Butterfly economics” Ormerod broadens his alternative (or already not) approach to economics. This book is a lasting attack on the premise that individuals’ preferences are fixed. Such premise ultimately leads to the belief that the economy can be controlled like a machine. Consequently, though orthodox economic theory has led to many explanations about business cycles and economic growth among other subjects, most of these explanations still have major flaws. The implications given are that major policies undertaken by governments are based on orthodox theory.
Ormerod’s point of view is based on the idea that what others do influences every individual’s behaviour. At the core of his thinking is the observation that human behaviour is not nearly as neatly predictable as prevailing economic models assume, and that makes economic life more like a living organism than a machine. Therefore, theory has to be adjusted to cover this fact. Ormerod goes on to illustrate a model that takes this into account and then shows how it could be used to explain, among other things, changes in crime rates, family structure, the business cycle and economic growth (Ormerod 2001:221)
Ormerod’s non-traditional methodology helps to analyse many of the problems that social sciences deal with. This book gives an idea of how economic theory is changing and shows how and why current economic orthodoxy failed. It gives light to a new way of thinking about a broad range of economic and social problems, and after the ongoing crisis, it is fairly possible that his main point will eventually be adopted by mainstream economics and other social sciences.
Every mistake is a lesson and a chance for improvement. It seems like the crisis of 2008 will not only remind that economy is not standing in one place, but will kill the traditional perceptions of the science as well.
References:
- Keane, M.& Runkle, D.(1998). “Are the financial Analyst Forecast of Corporate Profits Rational?”, The Journal of Political Economy, Vol 106, Issue 4, p. 768-805
- Krugman, P. R. (2009) The return of depression economics and the crisis of 2008, W.W. Norton, 191 pages
- Ormerod, P.(1997) The Death of economics, John Wiley & Sons, 240 pages
- Ormerod, P.(2001) Butterfly economics: a new general theory of social and economic behavior, Pantheon Books, 240 pages
- Sherden,W. A. (1998) The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley and Sons, 308 pages
- Tett, G. (2009) Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe, Simon & Schuster, 293 pages
