Why are economists so bad at making prognoses?

Economists are generally bad at making predictions; okay okay, bad is an understatement. Take the example of the last financial crisis, almost every economist missed that boat. The problem was not really about the bad loans being non-performing (not being returned), the problem was that a small number of non-performing loans were a part of fancy financial gadgets called derivatives. Basically, a derivative is a stake in a number of performing assets of different risk. The investors, on realizing the underlying loans were non-returning, tried to pull back their investment in the derivatives. The financial industry works in a way that allows the companies to leverage their initial investment to be many times the size. So when everyone panicked and tried to withdraw their investment at once, the system could not find the liquidity and stalled. As a result, Lehmann Brothers and Bear Stearns (the investment banks) failed (let’s set aside who got bailed out and who didn’t) as they had large holdings in derivatives.

Corollary: Why did the investment banks expose themselves to that extent? Because derivatives were touted as “safe” even after a small number of risky loans were built into the derivatives. The risk of losing money because of those loans not being paid up was, apparently, decreased by the less risky triple-A investments they were being packaged with. I guess the market didn’t believe that fiction. [Although when I read about derivatives the first time, I was wondering, “Aren’t derivatives simply a way of making the triple-A products more risky?”]

That was just one example of economists getting it wrong, there are many more peppering history.

But why do economists have a difficult time extrapolating from the past? Wait, don’t they get it right often enough? I’ll answer the second before going to the first question. They don’t get it right often enough. The number of times and the scale of the errors likely outstrips the number of times they called it correctly (within bounds for error). Here’s an introduction and a roundup of relatively recent ones: OECD Forecasts During and After the Financial Crisis.

Now: Why do economists have trouble extrapolating from the past? Aren’t they supposed to be able to make sense of trends and explain them? I’ll paraphrase a quote that’s stuck with me for a long time: Those who don’t remember the past are doomed to repeat it.

How does one “remember” an economic past? Not simply a paper trail (nice try), it’s in looking at the individual’s income and expenditure history, in other words, the individual’s wealth and its evolution. But little attention is being paid to anything to do with wealth, particularly wealth inequality. Almost all attention is focused on income inequality. The problem with income is, it is a flow; meaning there is a “time component” attached to measuring income. Hour/day/week/month/year, could be any of these or some other.

But are prices measured with a time component? Access to a market for a good or service requires a certain amount of wealth be had by that person to exchange for a good or service. As long as the person holds the required wealth, the person will be able to access the respective market. For example, having $2 gets you a cup of coffee for up to $2, and you can buy as many cups as you have $2 to spend and the will to buy.

Hence, if economists want to be able to extrapolate into the future, they will need to take the past into account as well, i.e. the wealth.

NB: If I sound repetitive, I made a similar argument before in a different style.

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