WHY ARE ECONOMISTS INCAPABLE OF FORECASTING ACCURATELY?

By Neel Shah

An economist, as defined by the Cambridge English dictionary, is a person studying the scientific system by which a country’s wealth is made and used. Therefore, the essential role of an economist is to study past changes in economic history, particularly focusing on those that don’t fit current theories or models. However, this research can only be useful in predicting and explaining future economic trends. Thus, an economist must be able to forecast effectively using both contemporary and revolutionary models.

However, work by Prakash Loungani at the International Monetary Fund (one of the leading global economic organisations) has shown that economists failed to predict 148 of the 150 past recessions. In addition, Brexit has shown that the significance of economists is flailing, with Michael Gove claiming, “People in [the UK] have had enough of experts.” Are economists doomed for failure, or do new models need to be developed?

45 years ago, while receiving a Nobel Prize in Economics, Friedrich Hayek stayed that economists were unsure of their forecasts, however the presentation of these forecasts as scientific fact was misleading and, “May have deplorable effects.” Yet, his words have been somewhat forgotten, with key political events highlighting the misuse of economic forecasts. So why do forecasts have a tendency to be incorrect?

First, let us consider recession. One of the main failures of forecasting is predicting recession, however this is not the fault of models but the economists using them. The reputational gain of predicting a recession that other economists have missed is overshadowed by the scepticism met from the community for disagreeing with the consensus. Since the downsides of failure outweigh the potential benefits of success, many economists choose to not display findings of recession. However, economists themselves are not the only hurdle faced in modelling.

Economic systems are also inherently complex to predict. As Mark Pearson of the OECD stated, “We are getting worse at making forecasts because the world is getting more complicated.” One of the reasons for this is feedback loops; let us compare meteorological forecasts to economic forecasts. If a meteorologist says it will be sunny, an individual will take wear sunglasses. However, this does not affect the probability of it being sunny. However, if an economist sets a forecast of 2% inflation, and individuals ask for a 2% wage rise in response, we have changed the underlying assumptions by which the model was made. As a result, inflation will likely rise by over 2%. This problem of feedback loops, particularly since more individuals are paying attention to economic forecasts, makes prediction increasingly difficult.

However, economists are usually able to accurately predict general trends in macroeconomic goals, the failures lie in extreme shocks, usually a result of external factors. In predicting a recession, organisations such as the OECD and IMF were 2.6% off figures on growth between 2007 and 2009 (based solely on one-year forecasts). This demonstrates a significant failure in prediction, presenting false trends, compared to only a 0.3% margin between 2010 and 2012. This is because exogenous shocks (any external factor affecting the economy) are worsened by speculation and direct response. This can be seen during the Great Recession, where investors pulled away from the West, towards China, who’s economy was not as distressed by the crash. This worsened growth figures in the West, particularly those of OECD members.

If economic forecasts are so inaccurate, can they ever improve? Personally, I believe that due to influences of globalisation, individual economies are too difficult to predict. However, improvement in forecasting is vital, since these forecasts account for decisions made by all economic agents. As a result, there should be no question as to whether forecasts will improve, since it is a necessity.

However, forecasts are just representations of the most likely figure, based on a range produced by most research organisations, including NIESR (an independent economic forecaster). As the image shows, forecasts include both the extremes and the predicted trends, which enables economic agents to prepare for all situations. This is because forecasts are based on a set of fixed assumptions, however factors can change. As a result, the most likely outcome is due to change. However, the range of possible outcomes is less likely to change, so it provides a better forecast for firms or governments to prepare from.