Category: Economics, Business and Finance

Economic Forecasting: What Is Going On?

The Times ran an editorial last Saturday (‘Predictable Mistakes’, Times, 3 Feb 2024) that was highly critical of economic forecasting particularly in the UK, pointing out that ‘among leading economies, British forecasters have distinguished themselves as the least prescient of the lot.’ A harsh assessment indeed and one with very serious consequences for all of us since, as the editorial went on to say, ‘bad modelling lays the ground for bad policymaking affecting investment strategy and monetary policy.’

            The Times editorial follows two recent columns in the Sunday Times which were also highly critical of economic forecasting. Dominic Lawson (‘Forecasts have one tiny flaw: they’re useless’, Sunday Times, 31 Dec 2023) compared economic forecasters to the augurs in Ancient Rome, a sort of priesthood distinguished by their supposed skills in predicting an uncertain future based on natural signs such as the behaviour of birds to determine whether the gods approved or disapproved of a proposed course of action. For “natural signs” read “econometrics”, but otherwise there is little difference in mindset – an overwhelming confidence, bordering on arrogance, in their superiority to the rest of us when it comes to transcending uncertainty.

              Dominic Lawson, who is the son of Nigel Lawson, the former Chancellor of the Exchequer, approvingly quoted his late father’s very perceptive comment on the fundamental problem with economic forecasting and economics in general being the illusion that because economic outcomes can be quantified, economic behaviour can be reduced to a set of mathematical equations. But, as Dominic Lawson argues, quantifiability does not mitigate the uncertainty inherent in economic behaviour. Economics is not physics; it deals with the irrationalities of economic behaviour not the behaviour of things that follow the laws of physics. And matters are made worse by the poor quality of much economic data, so much so that economic forecasters (and, hence, policymakers) are essentially flying blind. Lawson concludes his column with the rather damning comment that the time and money spent on forecasting human behaviour is a ‘monument to gullibility’. It reminds me of Deirdre McCloskey’s view that economics and econometrics are at times no more than the proverbial “snake oil”, sold by their purveyors as a cure-all but with little in the way of substantive evidence to support the marketing claims.

            Economists flying blind is the concern of Irwin Stelzer in his column, ‘Forecasting in the age of uncertainty’ (Sunday Times, 14 Jan 2024). Stelzer highlights the uncertainties in supply chains and how the interdependencies are transforming local and regional problems into global problems. It is a “butterfly effect” on a grand scale. Stelzer reminds us of the importance of Knight and Keynes as two economists who understood the difference between risk and uncertainty, and, crucially, recognised that investors fear uncertainty, not risk.

            I am reminded of a recent discussion with a senior economist of many years standing on the need for economics to embrace data analytics more thoroughly. In particular, as I have argued in recent posts, data analytics is data analysis for practical purpose and the necessary mindset for practical purpose demands a recognition of the importance of context. Although there are important differences between the approaches of Knight and Keynes (and I largely follow Keynes’s approach), both rejected the notion that uncertainty could be reduced to a well-defined probability distribution for a random process with a known, stable structure akin to the roulette wheel. The senior economist, who I would consider to be a radical economist strongly influenced by the ideas of Marx rather than modern mainstream economic theory, was very dismissive of my proposition that economics needs more data analytics. His response was that what economics needs is more sophisticated econometrics, not data analytics. Perhaps I should not have been surprised that a Marxist economist would believe in the predictability of economic forces. I suspect that Bernanke’s report on the forecasting capabilities of the Bank of England will reach a similar conclusion and argue for more sophisticated econometrics as the cure-all. But greater sophistication in econometric methods will not generate greater forecasting accuracy. Ultimately if there is no fundamental change in the mindset of economists and economic forecasters as regards the nature of uncertainty, there will be no change in the practical value of economic forecasts and policy advice. It is these issues that I intend to investigate in more detail in the coming weeks in a planned series of posts entitled ‘Risk, Probability and Uncertainty’.

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Analytics and Context

Putting Data in Context

The Dismal Science: A Personal Reflection – Part Four

Part 4: The Case For Practice-Led Economics

Executive Summary

  • Economics should be the science of hope in dismal times
  • The essence of mainstream economics is captured by the Robbins conception of economics as the study of the allocation of scarce resources among competing ends
  • All of the limitations of mainstream economics flow directly from conceptualising economic behaviour as rational choice – its de-contextualised universality, the emphasis on formal (mathematical) logic as the principal route to knowledge, the reduction of uncertainty to probabilistic risk, and the inherent laissez-faire presupposition against policy activism
  • The essence of the radical Keynesian approach is the Marshall conception of economics as the study of the everyday business of life
  • Radical Keynesian economics is a pragmatist, practice-led approach, grounded in the reality of everyday human economic behaviour and seeking to develop impact theory that provides practical solutions to real-world problems

I started this series of posts with the proposition that Carlyle’s characterisation of economics as the dismal science could be interpreted in two different ways. The negative interpretation is that economics is dismal in its attachment to a rather Panglossian view that “all is best in the best of all possible worlds” with little to be done by way of policy activism by government beyond regulations to protect the competitiveness of markets. From this perspective, the essence of economics is the invisible hand theorem that the price mechanism can ensure a Pareto-optimal general equilibrium provided that markets are free of structural and informational imperfections. In contrast, the more positive interpretation of economics as the dismal science is that economics tries to understand the world in order to provide ways to improve the well-being of people particularly in dismal times. Economics from this more positive perspective is a source of hope that lives can be made better by appropriate interventions by central government and other agencies. I align myself wholeheartedly with the view that economics should be the science of hope in dismal times.

              Much of the debates about the nature of economics and questions about the legitimacy of mainstream (neoclassical) economics can be summarised as the conflict between two fundamentally different conceptions of economics as a subject, what I will call the Robbins conception and the Marshall conception. In An Essay on the Nature and Significance of Economic Science (1931), Lord Robbins took the view that economics is the study of the allocation of scarce resources among competing ends. In so doing, Robbins rejected previous definitions of the subject matter of economics including that of Alfred Marshall, Professor of Economics at Cambridge. In his Principles of Economics (first published in 1890 and arguably the principal economics textbook for the first half of the 20th Century), Marshall had provided a very different definition that “economics is the study of the everyday business of life”.

The Robbins conception of economics captures the essence of the mainstream approach. Economic behaviour is conceptualised as a series of optimising choices by rational economic agents seeking to maximise their well-being (defined as utility for individuals and profits for firms) while operating as a traders in markets regulated by the price mechanism. All of the limitations of mainstream economics flow directly from this conceptualisation of economic behaviour as rational choice – its de-contextualised universality, the emphasis on formal (mathematical) logic as the principal route to knowledge, the reduction of uncertainty to probabilistic risk, and the inherent laissez-faire presupposition against policy activism.

              Mainstream economics ignores the broader context of human economic behaviour and imposes a universal frame of allocative choice in a market system. It adopts a rationalist, axiomatic approach to knowledge in which all economic behaviour is formalised as some form of constrained optimisation amenable to mathematical modelling. The market system is treated as structurally stable with uncertainty reduced to merely a series of random shocks with a well-defined probability distribution. Seemingly sub-optimal market outcomes are modelled as either optimal equilibrium outcomes under conditions of structural and/or informational imperfections or as disequilibrium outcomes with slow speeds of adjustment towards the optimal equilibrium outcome again due to structural and/or informational imperfections. Imperfectionist theories inevitably provide a weak basis for policy activism and tend to favour a more hands-off, laissez-faire approach by central government and other agencies directed more at market reform to remove the imperfections impeding the operation of the market mechanism.

              In aligning myself with a more radical vision of economics as the science of hope in dismal times, I adopt the Marshall conception of economics as the study of the everyday business of life. This summarises the essence of the radical Keynesian approach. Economics is grounded in the reality of everyday human economic behaviour. It is an inherently pragmatist approach of practice-led economics, what I called “impact theory” in Part 3 of this post. It is the “analytics” approach – analysis for practical purpose; analysis to provide practical solutions to real-world problems. It is an approach that open to the possibility that human economic behaviour is complex with often very different modes of activity that are much deeper than just price-based allocative decisions. Formal mathematical modelling and empirical data analysis both have roles in gaining knowledge just as in every other field of scientific endeavour. But there is a recognition that a pervasive feature of human life is uncertainty – we simple do not know the future. We act in anticipation of the future. Our actions are based on our beliefs, our understanding of the world but always with a recognition that our beliefs are partial understandings and the world is continually changing. And our actions are the product of both reasoned judgment and  emotional response to the specific context in which we find ourselves. Life is a process which we can influence but never full control. Structures change, sometimes suddenly and catastrophically leaving us asking “what is going on here?”, “what should we do?”. It is this pragmatist, practice-led vision of economics as the study of the everyday business of life to which this blog seeks to contribute.

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The Dismal Science: A Personal Reflection – Part Three

Part 3: Great Expectations – Discovering the Meaning of Keynes

Executive Summary

  • I read Keynes’s General Theory initially for its understanding of the macroeconomic consequences of uncertainty, subsequently for its insights into economic methodology and how to conceptualise the capitalist economy, and more recently as an exemplar of a pragmatist impact theory.
  • The General Theory is an “impact theory” that seeks to change not only how we understand the world but, crucially, seeks to change how we intervene to improve the world and the everyday business of life.
  • What really counts in the interpretation of an impact text is not the authenticity of the interpretation but the effectiveness of its actionable insights.
  • I claim no privileged position in understanding Keynes but only that Keynes has a privileged position in the formation of my own understanding of how real-world economies behave.

I came to Keynes by a rather circuitous route. Despite being immersed in the Keynesian-Monetarist debates, I never read Keynes’s General Theory as an undergraduate. The attitude to Keynes seemed similar to that of the pioneering scientists in the natural sciences. You didn’t need to read Newton’s own words to understand the laws of motion which are set out so clearly in modern textbooks; so too with Keynes I was taught. My dis-satisfaction with mainstream economics and the search for alternatives initially led away from Keynes in two main directions – Karl Marx and Herbert Simon. A final-year option on Marxian economics gave me a proper grounding in classical economics from Smith to Marx as well as an introduction to radical literatures that paralleled what I was studying in more mainstream courses on macroeconomics and labour economics. Marxian theories of crisis provided a radical alternative to macroeconomics while Marxian analysis of the labour process gave a radically different conceptualisation to that provided by implicit contract theory, segmented and dual labour markets theories, and New Keynesian imperfectionist theories. The course on Marxian economics also introduced an alternative perspective on the methodology of economics that broadened my horizons beyond Popper and Kuhn.

I was actually introduced to the work of Herbert Simon in my first-year undergraduate course on International Relations. I had to write a paper on the Cuban Missile Crisis and given my growing interest in economics, my tutor suggested that I read Graham Allison’s Essence of Decision. It was this book that persuaded me to specialise in economics since it introduced alternatives to the rational-agent model, particularly Simon and the behavioural theories of the firm of Cyert and March.

By the time I arrived at Cambridge for my graduate studies in the early 1980s, my interest in a more behavioural approach to economics had led me to the problem of understanding decision making under conditions of uncertainty, and that in turn led to the work of George Shackle. It was Shackle’s The Years of High Theory that ultimately opened my eyes to the importance of reading, really reading, The General Theory. So from the outset I approached The General Theory influenced by Shackle and Joan Robinson with a focus on Chapter 12 and what Keynes had to say about long-term expectations. I was very fortunate at Cambridge to be taught macroeconomics by Geoff Harcourt and Bob Rowthorn, a great combination for someone strongly influenced by both radical Keynesian and Marxian critiques of mainstream economics. Both were wonderful role models – radical economists with a thorough knowledge of the history of the subject who combined excellent theoretical skills with a deep understanding of real-world economies, and a strong commitment to improving the lives of others.

The early 1980s was an exciting time to be in Cambridge. Rod O’Donnell was just finishing his PhD on the philosophical foundations of Keynes’s General Theory and attending one of his seminars made me realise the importance of Keynes’s Treatise on Probability. This was reinforced by Gay Meeks who taught the graduate course on Philosophical Issues in Economics. She, more than anyone, was the real starting point for what I call the “New Fundamentalist Keynesian” project of re-reading Keynes’s General Theory from the perspective of A Treatise on Probability. Gay’s paper, ‘Keynes on the rationality of decision procedures under uncertainty: the investment decision’, was first completed in 1976 and circulated around Cambridge for many years but only published in the early 1990s in her edited volume, Thoughtful Economic Man. (It was reconnecting with Gay Meeks and Geoff Harcourt in 2018 that more than anything convinced me to return to economics and that I still had something significant to contribute to the subject.)

The Cambridge-Australian influence on my thinking was strong – Geoff Harcourt and Rod O’Donnell as I have mentioned, but also Peter Kriesler whose work showed me the importance of Kalecki’s contribution. Another Australian I met at Cambridge was Murray Milgate but, unfortunately, I have to admit that his influence on my thinking was more negative. I disagreed profoundly with the Neo-Ricardian project led by John Eatwell and Murray Milgate to create an alternative economics based on Sraffa’s theory of value and Keynes’s principle of effective demand. I attended Eatwell’s undergraduate lectures as well as taking his graduate class. Milgate’s doctoral research on the Neo-Ricardian interpretation of Keynes was published as the book, Capital and Employment, while I was at Cambridge. A detailed critique of the Eatwell-Milgate position became the central focus of my graduate dissertation. I argued that the Neo-Ricardian model, like so much of classical and neoclassical economics, is a static equilibrium model devoid of historical time. In particular Eatwell and Milgate had relegated both short-term and long-term expectations to a mere friction in Keynes’s model whereas I saw the fragility of the state of long-term expectations as central to Keynes’s explanation of involuntary unemployment. In retrospect I realise that I fell into the trap that bedevils economic and political radicalism – devoting too much time and effort on arguing with other radicals on who possesses the “truth” rather than emphasising the commonality of purpose and focusing on countering the arguments of those advocating conservatism.

My Economic Journal 1991 paper in which I drew on hermeneutics to understand the multiple interpretations of Keynes’s General Theory is more reflective of a recognition that the enduring power of The General Theory is its ability to generate multiple interpretations leading to a diversity of research efforts. As a practical economist the concern is the significance of the interpretation as an understanding of real-world economies and as a guide to action. Practical significance is the ultimate criterion of justification for any proposed interpretation of Keynes, not whether or not it represents what Keynes really meant. Authenticity is unattainable in interpretation; at best all we can achieve is an interpretation that is consistent with the text and other related evidence. The General Theory is an “impact theory” that seeks to change not only how we understand the world but, crucially, seeks to change how we intervene to improve the world and the everyday business of life. What really counts in an impact text is the effectiveness of its actionable insights.

Keynes’s General Theory remains powerful and relevant today even although real-world economies have changed massively over the last 90 years or so. There are enduring insights into the behaviour of the economic system, and the limitations of how mainstream economics conceptualises and theorises that behaviour. I read The General Theory initially for its understanding of the macroeconomic consequences of uncertainty, subsequently for its insights into economic methodology and how to conceptualise the capitalist economy, and more recently as an exemplar of a pragmatist impact theory. I claim no privileged position in understanding Keynes but only that Keynes has a privileged position in the formation of my own understanding of how real-world economies behave.

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The Dismal Science: A Personal Reflection – Part Two

Part 2: Mainstream Macroeconomics – A Nothing-New Consensus?

Executive Summary

  • The postwar Neoclassical Synthesis in mainstream macroeconomics has been replaced by the New Consensus Macroeconomics which combines elements of both New Keynesian Economics and New Classical Economics
  • New Keynesian Economics is effectively just the macroeconomics of market failure with policy activism justified by price and wage stickiness due to structural and informational imperfections
  • New Classical Economics integrated the rational expectations hypothesis into a macro-clearing equilibrium model of the macro economy to provide a powerful argument against policy activism
  • The New Consensus Macroeconomics, just like the earlier Neoclassical Synthesis, reduces the Keynesian-Neoclassical argument over the effectiveness of policy activism to a purely empirical question of the speeds of adjustment and the degree of price and wage stickiness

When I started to study economics in the mid-1970s, it was a period of rapid theoretical development in mainstream macroeconomics. The established post-war consensus in mainstream macroeconomics built around the Neoclassical Synthesis was breaking down because of the obvious disconnect between the rational-agent/constrained-optimisation models of microeconomics and the simple IS-LM and AD-AS macro models based on seemingly ad hoc behavioural assumptions. The search was on for the appropriate microfoundations of macroeconomics. Those of a more Keynesian disposition focused initially on disequilibrium models, providing a sophisticated treatment of quantity adjustments when prices are slow to adjust. But this still left open the question as to why prices, particularly, wages were sticky. Ultimately this led to the emergence of the New Keynesian Economics (NKE) in the 1980s/1990s with a veritable proliferation of choice-theoretic models of price and wage stickiness. The invisible-hand theorem of self-equilibrating markets requires a whole set of structural and informational conditions to be met. Relaxing any of these assumptions and allowing for imperfections could explain why prices and wages might be slow to adjust, or indeed never adjust fully, to the perfectly competitive (full-employment) equilibrium. The NKE is effectively just the macroeconomics of market failures.

              The alternative search for microfoundations focused on the dynamic behaviour of rational agents under conditions of stochastic uncertainty. The New Classical Economics (NCE) rejected the ad hoc assumption of adaptive expectations that had been used in the expectations-augmented Phillips curve (EAPC) to justify the possibility of effective short-run stabilisation policy. The NCE adopted instead the rational expectations hypothesis (REH), assuming that rational economic agents are fully informed of the systematic behaviour of the economy with expectational errors due to unpredictable shocks to the economic system. The NCE integrated the REH into a market-clearing equilibrium model of the macro economy to provide a powerful theoretical argument against policy activism. The NCE argued for a Panglossian world characterised by REH, information-efficient markets, and policy irrelevance. Two influential NCE propositions were Ricardian equivalence and the Lucas critique, both of which reinforced policy irrelevance. Ricardian equivalence implies that forward-looking rational agents treat debt-financing and tax-financing as equivalent so that fiscal policy has no first-order impact on aggregate demand. The Lucas critique recognises the endogeneity of behaviour responses to policy changes with forward-looking rational agents, making the construction optimal policy responses to economic shocks as something of a will-o’-the wisp.

The New Consensus Macroeconomics combines elements of both NKE and NCE. The simple macro model is in many ways just a modern version of the ISLM and AD-AS models of the Neoclassical Synthesis. The IS and AD curves are retained with the supply side represented by the EAPC (incorporating the REH) and the LM curve replaced by a Taylor-type monetary rule relating the nominal interest rate to deviations in inflation and output from their target levels. The case for activist stabilisation policy remains an empirical question of the speeds of adjustment and the degree of price and wage stickiness. In a very real sense the New Consensus Macroeconomics is a Nothing-Fundamentally-New Consensus Macroeconomics.

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The Dismal Science: A Personal Reflection – Part One

Part 1: The Rip van Winkle Effect

Executive Summary

  • The Rip van Winkle effect is the move from an insider perspective to an outsider perspective after a significant period of time with little knowledge of what has happened in the interim
  • Carlyle viewed economics as the dismal science in a very negative way as a science that provides a very dismal laissez-faire conclusion to leave well alone since activist policies cannot improve the economic condition
  • I take a much more positive view that economics is the dismal science in the sense of being the science of how to intervene to help human beings in dismal times.

As an undergraduate student in the mid-1970s, I remember reading Robert Gordon’s 1976 Journal of Monetary Economics paper on recent developments in macroeconomics using the Rip van Winkle device. Gordon asked the question as to what would Rip van Winkle have found so different about the theory of inflation and unemployment in 1976 if he had been asleep for 10 years. I feel in a similar Rip van Winkle position today. After 20 years in economics, I left the academic subject in the mid-1990s. There were many reasons for my exit, partly disillusionment and loss of passion, partly because I thought that I really had nothing more to say that was new, and partly because I wanted to make a practical difference. After leaving economics, I moved into accounting and finance, then data analytics, still working as a business-school academic but also involved in supporting coaches and executives in elite sport. Now 25 years further on, my passion for economics has been reignited and I have started to again present at economics conferences and publish in economics journals. But I now have a very different perspective on economics, what I’ll call the “Rip van Winkle effect” of moving from being an insider to being a complete outsider with little knowledge of what other insiders have been up to in the interim. And these days I am not just an outsider to mainstream economics; I am an outsider to all economics including radical economics. But crucially my outsider’s perspective is a much more pragmatic, practice-oriented perspective that is not so heavily constrained by the demands of the academic discipline. 

Thomas Carlyle, the 19th Century Scottish philosopher, described economics as the dismal science because, as he saw it, economics rather dismally claims that supply and demand is the secret of the Universe which leads to the laissez-faire directive of “letting man alone”, a very dismal conclusion that we can do nothing to improve the economic condition. As a radical Keynesian I fully understand Carlyle’s attitude to (mainstream) economics. But I have always considered economics to be the dismal science in a more positive sense of being the science of how to help human beings in dismal times. I started my studies of economics in the mid-1970s in a post-Watergate/post-Vietnam world suffering the consequences of the first oil price shock, the onset of a world recession and rampant stagflation. I was drawn to the later economics of John Maynard Keynes developed in the dismal times of the 1930s in which the world had to deal with the Great Depression, the rise of totalitarianism and the prospect of global military conflict. Economics to me has always been about making a positive difference to people’s lives, particularly in dismal times. When we look at today’s world and the immense problems faced, the need for an activist economics is as great as ever. But sadly economics is still failing to respond in any meaningful way to the challenges of our times, as wedded as ever to its core Panglossian instinct that all is for the best in the best of all possible worlds. Over the next three weeks I will provide my outsider’s thoughts on the current state of economics, both mainstream and radical.