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In defence of economics

In defence of economics

What use are economists? This has been a common question provoked by the profession's complete failure to forecast the 2008 recession. I think it has a powerful answer.

First, let's be clear. Economists cannot foresee the future, because the future is unknowable, at least when it matters. But economics is not unique in having no foresight. Other social sciences fare little better. (And, one might add, the natural sciences too; Fabrice Muamba had several heart scans in his short career and none forecast that his life was in peril).

Instead, the utility of economics lies elsewhere. For our purposes, it can help savers and investors to manage their finances and, if not make money, then at least avoid the most egregious ways of losing it. (For a good survey of economists' study of household finances, see this lengthy paper). I'd stress four aspects here:

1. Although economists don't know the future of asset returns, we do know their distribution and risks. It's become increasingly clear that returns follow a cubic power law. This means large losses are more likely than you think.

Economists also know that there are various types of risk – not just market risk, but cyclical risk, correlation risk, liquidity risk, behavioural risk, and so on.

2. Economists have made detailed empirical studies of investors' actual behaviour. These have yielded important results. Not least are that most active stock-pickers lose money, and that professional fund managers have only a handful of good stock ideas.

3. Economists know the maths of portfolio formation. This tells us when diversification works and when it doesn't. It also has what might be a surprising result – that cautious investors should not hold more defensive stocks than more risk-seeking ones.

4. Economists have become increasingly aware of the cognitive biases that lead investors astray. Some of these – such as the tendency to overconfidence – can cost money by encouraging too much trading. More rarely, some others, such as the tendency to under-react, can help make money by allowing us to exploit momentum effects.

Economists can also use artificial models or laboratory experiments to help quantify just how expensive such cognitive biases can be.

This sort of knowledge means that economists can offer good financial advice.

But here's the thing. There's more demand for the pseudo-economics of forecasting than there is for proper, helpful and – yes - scientific economics; just compare the salaries of economic forecasters to those of the authors of the papers I've linked to. In economics, there is a form of Gresham's law – people prefer the bad to the good.

One reason for this is that the same overconfidence and optimism biases that we know to be costly also make people deaf to economists' warnings that markets are risky and success unlikely. People want simple stories that’ll make them money. Throughout history there has been a demand for seers, necromancers and witchdoctors. Forecasters supply this demand; proper economists do not.

In this sense, we should not be too hard upon economic forecasters. There's one thing stupider than forecasting the future - and that's paying for such forecasts. Just don't confuse economic forecasting with proper economics.

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By Chris Dillow,
12 April 2012

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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