Economic forecasting – voodoo or science? Part 1: Impossible, yet essential

“Forecasts usually tell us more of the forecaster than of the future.” Warren Buffett

A forecast or prediction is a statement about the events, conditions or developments that are expected to happen in the future. The difference between a forecast and other statements about the future, e.g. prophecy, is that it is based on knowledge, derived scientifically.

Forecasts are central to practical economics. They are made, on the one hand, by economists and related to macro-measures of economic performance such as gross domestic product, inflation or population growth. On the other hand, financial analysts draw up forecasts about corporate developments, which they express in terms of changes in turnover and profit. Predictions can also be made about the development of market prices, e.g. about the price targets of shares, indices, currencies or interest rates. These are fundamentally very problematic, because they involve anticipating both economic events and the reaction of the players on the market to these events.

“Prediction is very difficult, especially about the future” is a popular quote, attributed to the Danish physicist Niels Bohr (although some claim that it was originally said by Mark Twain, Winston Churchill or Kurt Tucholsky). It states that it is basically impossible to predict the future because it is uncertain and we cannot know what it holds. For this reason, there is widespread scepticism about forecasts. And this scepticism is further fortified by economic predictions, as they frequently turn out to be completely wrong.

Nevertheless, forecasts are a crucial basis for all investments. To evaluate how worthwhile an investment is, a realistic estimation of its future earnings potential and risks is necessary. Making an investment is always like betting on the future and implicitly therefore also like making a forecast, even if this is not explicitly stated. For this reason, one of the latest fashions on the money market, – the so-called “forecast-free” approach to investment decisions – is a clear case of fraudulent labelling. Ignoring the necessity of forecasts does not help to solve the problems related to them – quite the contrary.

Impossible, yet essential – this summarises the basic problem of forecasts. However, does this really paint an accurate picture of the situation? The fact that many mistakes have been made does not necessarily imply that forecasting is fundamentally impossible; it may also mean that it is not performed professionally or is implemented inappropriately.

In practice, it is particularly difficult to differentiate between genuine forecasts and prophecies, which are presented as if they are scientific. The way in which predictions are presented mostly does not actually tell us much about how they have been drawn up: Have they really been conducted in a scientific manner? Or are they only pseudo-science, which – just like voodoo magic – is merely a performance to conceal the fact that they have no substance?

Forecasts are made regularly about other areas than the economy. In these other areas, however, they are a lot more reliable these days. In particular, opinion polls and meteorologists usually produce significantly more accurate forecasts. In my opinion, economists and analysts have problems generating accurate predictions in comparison to other groups of forecasters for two main reasons:

1) Drawing up economic forecasts involves specific methodical complexities, for the following reasons:

  • the quality of the underlying assumptions and data;
  • the extent to which the forecast allows for a margin of error;
  • the time frame, for which the forecast is made.

2) The emergence of economic predictions results in systematic distortions and in the exploitation of these distortions in their social context. The explanations for this are:

  • the forecaster is biased;
  • forecasts are made for specific target groups and for specific purposes;
  • the outcome is in reality influenced by the prediction.

These points will be explained in more detail in further articles in the following days.

 

*) Warren Buffett’s quote is from his essay: “How inflation swindles the equity investor”; first published in Fortune 1977

Posted in Economics, Financial Markets

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