When economists turned the spotlight on themselves at Davos

The just-concluded meeting of the World Economic Forum at Davos had proved to be a virtual non-event, overshadowed as it was by the crisis in the Islamic world.

But economists basked in the limelight as they were a much-sought-after tribe. Their wide-ranging forecasts — the likelihood of the next economic crash, growth outlook for China, the possibility of a debt crisis, et al — were in demand, at a time when their track record has never been more pathetic — a fact that, ironically, came to the fore in the conference itself.

Economics, we all know, is not an exact science and, when it comes to forecasts of this profession, taking them with a generous pinch of salt would be in order.

How credible are these forecasts? In his thought-provoking Three Sacred Cows of Economics, Alex Rubner spoke of an economist who had forecast the age of a river as one million and twenty-one years.

Asked how he can be so accurate, the economist replied that, twenty one years ago, the age of the river was estimated at one million years.
Nearer home, the Reserve Bank of India, when it came to projecting the inflation rate by the end of March 2011, it had simply shifted the sign post. In stead of the earlier 5.5%, it has now revised it to 7%.

Why? Because between the second- and third-quarterreviews, the underlying price scenario had changed for the worse.

When the forecasts cover a wide field and many uncertainties loom large, the perils of economic prediction are obvious. But, undeterred, at the World Economic Forum 2011, five top contemporary economists ventured to predict the future of economic forecasting.

Writing in Ha’aretz, the respected English language daily in Israel, Eytan Avriel, the paper’s business editor who had covered the Davos conference, was at his caustic best. “They did not foresee the financial crisis 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.”

But economists are not the ones to shy away from problems and this time around in Davos, they understood that they are the problem.

At a closed-door dinner session, some of the best minds in the profession decided to turn the focus on themselves.

Among the galaxy of attendees were such luminaries as Robert Shiller of Yale University, Joseph Stiglitz, the Nobel laureate, Simon Johnson of MIT Sloan School of Management , Raghuram Rajan, formerly director of research with the International Monetary Fund and now with the Chicago Booth School of Business, and professor Carmen Reinhart of Maryland University.

And, for a change, this debate generated more light than heat. The underlying complexities were examined — the uncertainties, the political factors, natural disasters, outbreak of wars — and why forecasts based on such variables tended to go wrong.

As one executive of an asset management company put it, an economic forecast is one input among many. It could be the starting point of an analysis or discussion.

Raghuram Rajan referred to IMF’s forecast about Africa, which was belied when the economy of one country had collapsed following an outbreak of conflict, impacting the growth estimate of the entire continent.

Robert Shiller argued that, economic forecasting is not like weather forecasting; in the latter, certain parameters are known and the predictions pertain to a few days only. In economic forecasting, the forecasts are long-term and are based on mathematical models, which, in turn, depend on a set of factors that are in a state of flux such as resources, technology and the like.   

Reinhart spoke of the deficiency of the mathematical models in that they do not take into account all the factors; that human nature is such that, when a crisis occurs only closer home, they tend to take it seriously.

The Latin American crisis was a far-off event for Asia till they were forced to contend with one. Stiglitz referred to the herd mentality and the unwillingness of economists to be out of sync with the consensus view.

If the powerful chairman of the Federal Reserve said that he had a new paradigm and others disagreed, the people naturally are carried away with the view of the Federal Reserve chief, argued Stiglitz.

Avriel of Ha’aretz best summed up the outcome of the Davos discussion on economic forecasting. He lists ten reasons why economists always get it wrong. They are set out below in a summary form:

1. Economists never stood a chance. As Shiller stated, forecasting doesn’t work. It never did. Economics is too complex and nobody can predict what humans will do.

2. You can’t predict a turning point. Reinhart, who had co-authored a book, This Time is Different, says one can predict when a country or economy will tumble into a trouble bad enough to cause a crisis, but one can’t predict when. To Stiglitz, forecasts are merely mid-updates of previous forecasts and they provide little value addition to policy makers.

3. Models assume that economies are stable but they aren’t. Traditional economic models, like those based on econometrics, assume that economies and the data put into the formulae are stable but this is nonsense.

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

5. Economists are afraid to break ranks with the consensus. If they are wrong, there goes their career overnight. It is a human dynamic. As no one dares say otherwise, the consensus goes stronger and becomes even harder to buck.

6. Forecasts affect the economy. How can you create an accurate forecast when the forecast itself will influence human behaviour and change things?

7. Forecasts influence politicians, but you can’t tell how they will react. Politicians, mainly the ones who set economic policy, may not behave rationally as the models would suggest. A politician approaching an election may not behave the same way as one just elected.

8. People look for short cuts, but there aren’t any. The dictum — devil is in the detail — is often overlooked. Many prefer to focus on GDP, growth, debt/GDP ratio and current accounts in stead of the economic analysis in depth and think of alternative options.

9. Economists believe their own stories. Throughout history, people have claimed that “ this time, it’s different” or “our case is different”. It never is.
10. When the economy is roaring and confidence is soaring, control mechanisms collapse. Checks and balances disappear. The governments make the biggest mistakes when the forecasts are sunny.

But human nature is such that, though the economic forecasts were mostly wrong, everybody still demanded them, remarked a banker who had attended the Davos meet, though he ruefully admitted that the economists who advised his firm got it right only three or four times out of ten.

In India, too, economic forecasting is now an obsession. With the launch of economic reforms nearly two decades ago, and our greater integration with the rest of the world, both the range and number of economic forecasts have increased. Whatever be the quality or the outcome of economic forecasts, one thing is beyond doubt — they are here to stay and their practitioners have a bright future.