Friends, Romans and Countrymen,
Economists are humble men.
Macroeconomists using their favourite plaything, past data, predict long term trends for a country. Their forecasts, which have the power to shape economic destiny of countries, are not restricted to broad shifts in output, prices, or other metrics, but are quite often very exact estimates (regularly in two decimal places) of where an economy would be after a certain period of time.
Let’s take an overview of such forecasts in light of the recent controversial notebandi or what has been labelled as ‘Demonetisation’.
A Reuters poll of 30 economists forecasted Q3 GDP growth at a 3-year low of 6.4% while some analysts feared a sharper slowdown to less than 6%.“We are projecting the Q3 GDP growth at 5.8%.” said Soumya Kanti Ghosh, Chief Economic Advisor for the State Bank of India. Equally assertive were private sector economists such as CARE Ratings Chief Economist Madan Sabnavis, who saw growth slowing down to as much as 5.4% in Q3.
What really happened?
The dark art of macroeconomic forecasting, as Prof. Indradeep Ghosh at MDAE likes to call it, failed in predicting the exact GDP growth rate of the country during Q3 2016-17. The Indian economy grew at 7% during this quarter as per the Central Statistical Organisation (CSO). Now the CSO does admit that economic activity has been impacted by the note ban with Q3 GVA growth at 6.6%, against 7% last year. Gross Value Added (GVA) is a more suitable number than GDP. The GVA measures the value of output created by different segments of the economy. Indirect taxes (minus subsidies) are added to it, to arrive at the GDP.
CSO’s estimation has been criticised for not showcasing the input of the informal sector, but it can be argued that if the CSO can’t find a way to estimate the quarterly performance of the informal sector despite having access to arguably the most reliable multiple data sources, neither can anyone else. Clearly those macroeconomists with their exact predictions have missed a trick or two. This in no way is a defence of notebandi, I believe the best analysis on the Demonetisation experiment was offered by Lebanese-American essayist and Risk Trader Nassim Nicholas Taleb who concluded that it’s “too early to tell” about the consequences of the monetary experiment.
We’ve seen similar deformities in macroeconomic predictions pertaining to two other significant events around the world last year. The recession forecast produced by the U.K. Treasury ahead of June’s Brexit vote which assumed monetary policy would be unchanged and the prime minister would immediately initiate the process of leaving the European Union was proved wrong; the U.K. economy has been faring decently well. Similarly in the case of Donald Trump’s election to the White House, the economic and market mayhem that was expected and warned against by several pandits has been missing and rather conspicuously so. .
Nobel Laureate Friedrich Von Hayek can perhaps help us understand the reason behind why despite this hubris, macroeconomists fall flat faced in their predictions. Let’s ask ourselves, what would Hayek say?
In his Nobel Memorial lecture titled the ‘Pretence of Knowledge’, Hayek says that if we truly wish to advance society, we must be modest and realise the limitations of what is possible with social science.
According to him economists can’t provide the kind of exact data that natural scientists are expected to produce as the variables that economists study cannot be summarised or averaged.
Hayek in one of his papers, ‘The Counter-Revolution of Science’ observes that the natural sciences attempt to remove the “human factor” in order to obtain objective, strictly controlled results:
The persistent effort of modern Science has been to get down to “objective facts,” to cease studying what men thought about nature or regarding the given concepts as true images of the real world, and, above all, to discard all theories which pretended to explain phenomena by imputing to them a directing mind like our own. Instead, its main task became to revise and reconstruct the concepts formed from ordinary experience on the basis of a systematic testing of the phenomena, so as to be better able to recognise the particular as an instance of a general rule.
Meanwhile, the social sciences are attempting to measure human action itself.
The social sciences in the narrower sense, i.e., those which used to be described as the moral sciences, are concerned with man’s conscious or reflected action, actions where a person can be said to choose between various courses open to him, and here the situation is essentially different. The external stimulus which may be said to cause or occasion such actions can of course also be defined in purely physical terms. But if we tried to do so for the purposes of explaining human action, we would confine ourselves to less than we know about the situation.
A discipline like economics studies complex structures consisting of individuals with distinguishable identities who are connected with one another through meaningful linkages. Any attempt to summarise or generalize over these ‘subjects’ means losing out on critical information.
Hayek also believes that unlike natural sciences, the variables economists pick to measure may not be the most pertinent ones. This can lead to economists imprecisely emphasising on the few variables that can be measured as they are easier to study and ignoring the other ones by pretending that they are not significant. As he quips:
The study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process will hardly ever be fully known or measurable.
In a recent paper Paul Romer, Chief Economist and Senior Vice President of the World Bank claimed that macroeconomics has been going backwards for more than three decades, with economic modelling succumbing to “mathiness”, an obsession with mathematic laws and equations which bear minimal relation to the real world, ignore the lessons of other disciplines, and are often inconsistent with the inherently unpredictable nature of human behaviour. Another economist in the upper echelons of the profession Andrew G.Haldane, the Chief Economist of the Bank of England recently admitted to the errors in the Brexit forecasting. He acknowledged that his profession is in crisis, having failed to foresee the 2008 financial crash and having misjudged the impact of the Brexit vote.
Question: why did God create economists? Answer: to make weather forecasters look good!
The only difference being that weather forecasts can’t alter the weather, but economic forecasts can surely change the course of an economy. One might hope that more economists, especially the ones with significant powers to influence policy, both in India and around the world, eat the humble pie more often.