Economists and market strategists did not predict the current recession.
By ERAN PELEGfinancial crisis stock market 298.175(photo credit: AP)
We are at the beginning of a new year, and as always, we are flooded with economic and financial market forecasts for 2021. Please make sure you disregard them.Economists and market strategists did not predict the current recession. I admit – it was a tough one to forecast. It was very difficult to envisage the outbreak of the COVID-19 pandemic on such a global basis and the way in which governments reacted to it. However, economists have failed to predict most economic recessions we have encountered over the past decades. And yet, the yearly ritual of forecasting continues.Stating that forecasts are completely useless is perhaps taking it to an extreme. They can sometimes be useful. They can serve as a basis of a fruitful discussion about possible scenarios for the future. Furthermore, examining the forecasts published by a wide range of sources, they can also help sophisticated investors to ascertain what is the current consensus market view. Having said that, do make sure that you do not get carried away and fall into the fallacy of seeing them as reliable picture of what is expected in the coming year.The long-standing practice of economists and financial market strategists generating, and publishing, forecasts lies in the aspiration, or at least the will to create the perception, that economics and financial market analysis have a resemblance to the natural sciences. This creates a much-desired aura of ‘science’ to the economic profession.But reality is that economic and market forecasting is an impossible task. In the natural sciences, it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable. However, when it comes to the economy and financial marketplace, all the circumstances which will determine the outcome of a process will hardly ever be fully known or measurable. Furthermore, a small change in a few variables can make predictions almost impossibly complex. And finally, and most importantly: Economics is a social science. It focuses on human beings. The way in which individuals will perceive and react to economic and market developments will have an impact on the outcome. This is very different from in the natural sciences. If they predict it will rain, whether I take an umbrella or not will not affect the weather. The outcome is not conditional upon my action. However, the action that individuals take, for example, upon hearing that we might be entering a recession – whether they decide to ignore this news or start aggressively reducing their expenses (in order to save for the potentially more difficult times ahead) – will actually affect whether or not we end up in such a recession (this feedback loop stands at the center of the notion of reflexivity in economics).Predictions tend to work well only in systems which are isolated, stationary and repetitive. That is not the case in social sciences. In the most fundamental sense possible, every event in human history is discrete, unique and novel. Having just experienced the COVID-19 pandemic and, at least for a while, a nearly complete shutdown of the global economy, I do not believe I need to add much to convince people of this point. For this reason, it is impossible in principle that unconditional scientific predictions could be made in relation to human history. Karl Popper, one of 20th century’s most influential philosophers of science, summed it up nicely: “The fact that we predict [solar and lunar] eclipses does not, therefore, provide a valid reason for expecting that we can predict [social] revolutions.” (Conjectures and Refutations, 340).Investors need to put aside single-point forecasts and adopt probabilistic thinking. They need to make sure that they build portfolios that can withstand a wide range of future economic and market scenarios. Finally, any attempt to reduce the investment profession into the mathematical tools that we deploy, reflects a misunderstanding of economics and financial markets. With economics being fundamentally a social science that focuses on human beings, economists and financial market professionals need to maintain a broad multidisciplinary approach. They need to understand economics – but also politics, sociology, history, psychology and philosophy.The writer is Chief Investment Officer, Clarity Capital
