All That Glitters / Ten Reasons Why Economists Always Get It Wrong

Economists did not foresee the financial crash of the west, or the collapse of Western property values; and after the event, almost none foresaw the rapid rebound of some economies, or the meteoric rise of stocks, which have recouped all their losses and then some.

Economists usually swan in the spotlight at the World Economic Forum at Davos. Not this year, or last: Their reputation is shot.

They did not foresee the financial crash of the west, or the collapse of Western property values. And after the event, almost none foresaw the rapid rebound of some economies, or the meteoric rise of stocks, which have recouped all their losses and then some.

Davos Resort - AP

The result is predictable: Faith in their forecasts has never been this low. So many economists are beating their breasts and yowling for economic theory to be rethought, this time in a way that will enable them to foresee (and thus, hopefully, prevent ) meltdowns of the sort that all but destroyed the global financial system, causing tens of millions to lose their jobs.

But why did they get it wrong? At a closed-door dinner at Davos, leading minds in economics such as Robert Shiller, Joseph Stiglitz, Simon Johnson and Raghuram Rajan discussed that embarrassment, and, ironically, tried to predict the future of economic forecasting.

The result, dear reader, is 10 reasons why economists get it wrong, and why you shouldn't expect that to change any time soon.

1 They never stood a chance. Shiller pointed out the obvious: Forecasting doesn't work. It never did. Not only is economics too complex: even weather forecasts, which depend on purely physical parameters (not psychological ones as well ) are a hit-or-miss affair and can't go beyond a few days. Nobody can accurately forecast what humans will do.

Shiller says economists and scientists are too enamored of their formulas, but humans, whose behavior moves economies, don't obey the math. He also thinks that modern economics is driven by hidden catalysts that nobody understands, which meanwhile can have a devastating effect.

Raghuram's contribution: Like war, economics is the sum of all human behavior. Every time the International Monetary Fund tries to predict something about Africa, it's wrong, he points out. That's because every time some country embarks on a civil war or some other war, its GDP collapses and it ruins the continent's average.


2 You can't predict the turning point. Carmen Reinhart and and Kenneth Rogoff recently wrote a book called "This Time Is Different." They say one can predict that a country or economy will stumble into trouble bad enough to cause a crisis, but one can't predict exactly when. Stiglitz sadly concurred and added that forecasts are merely mild updates of previous forecasts; he says they're of little added value to policy makers.


3 Models assume that economies are stable. But they aren't. Traditional economic models, the types based on econometrics, assume that economies, and the data put into the formula, are stable, but it's nonsense. For example, rating agencies ranking complex bonds and debt structures used completely irrelevant formulas.


4 Economists tend to focus on accepted parameters and economic ratios while ignoring warning signs, unless the warning sign hits them over the head.


5 Economists are afraid to break ranks with the consensus. If they're wrong, there goes their career overnight. It's a human dynamic: As nobody dares say otherwise, the consensus grows stronger and becomes even harder to buck. In other words, economists are human, and they err.

6 Forecasts affect the economy. How can you create an accurate forecast when the forecast itself will influence human behavior and change things? When the governor of a central bank says the economy can overcome a given real estate bubble, he makes the bubble grow all the bigger and his forecast becomes irrelevant.


7 Forecasts influence politicians, but you can't tell how they'll react. Politicians, mainly the ones who set economic policy, may not behave rationally as the models would suggest. A politician approaching an election won't behave the same way as one just elected. The most contemporary example is Germany and the debt crisis in Europe. All forecasts depend on how Germany will behave, but nobody knows how Germany will behave. So making an accurate forecast is borderline impossible.


8 People look for shortcuts, but there aren't any. Most people wouldn't read an economic analysis in depth. They'd rather cut to the chase and look at the bottom line - GDP, growth, debt/GDP ratios or current accounts, but don't have the patience to read studies and alternative opinions. Shiller suggests that many market failures that stood out in all their ugliness in the last crisis had been foretold in the economic literature, but almost nobody had read it and noticed. The same is true of national statistics. On the face of it, Spain's economic figures for recent years showed economic health, but the devil in the details was there to see.


9 Economists believe their own stories. Throughout the history of economics, people have claimed that "this time it's different". (Or, our case is different ). It never is. Economists know perfectly well that heavy debt brings big trouble, but they ascribe the trouble only to developing economies, not the West. They thought that technical acts like securitizing debt would change the world, and that economics would suddenly start behaving differently, despite centuries of history. It didn't. They were wrong.


10 When the economy is roaring and confidence is soaring, control mechanisms collapse. Reinhart describes that, for instance, during the years when the euro beefed up, checks and balances disappeared. The forecasts were sunny - and that's exactly when governments make policy mistakes. In the case of the euro zone, it was clear that the countries' economic data were artificially biased on the upside. The result is that soon enough the forecasts were proved wrong: The very rosiness of the forecasts caused the brakes of critique to fail.

Given the superlatives heaped on the Israeli economy, augmented by the natural-gas discoveries and the arrogance of our politicians and managers, we can only hope that Israel won't be the next to fall into that trap.