For the last couple of months I have been writing a weekly column for the Icelandic newspaper Fréttablaðið. I enjoy it a lot. First of all it keeps me in contact with Iceland – a country that since 2006 has been an important part of my professional and personal life. Second, it is a good alternative to my blog where I mostly focus on monetary policy.
I normally do not share the stuff I write for Fréttablaðið on this blog, but will do it from time to time in the future if I think that others than an Icelandic audience can benefit from reading it and it fits the “profile” of my blog.
An example of this is the largest op-ed, which has been published today. Have a look at the Icelandic version here.
Here is the English version…
Do economists know what will happen in 2016?
I am not going to lie – I am proud of my forecast in 2006 that Iceland would be facing a server economic and financial crisis. However, I am always very humble about the fact that to forecast something correctly you have to a large extent to be lucky and I generally don’t think that economists or political scientist for that matter are especially good at forecasting.
In fact – and that might be a surprise to most non-economists – when you study economics there is not a course in “forecasting”. It is simply not what economists are educated to do.
What economist on the other hand can do is analysis the impact of different shocks to the economy or analysis the impact of for example an increase in the minimum wage.
Said in another way economists are very good at in hindsight explaining what happened and why it happened. The reason for this is that what economist cannot forecast shocks – for example an earthquake, a terror attack or for that matter a major positive technological development – since a shock by definition is exactly that something you didn’t see coming.
How economists actually “forecast” – reversion to the mean
So what do for example bank economists do when they try to forecast what will happen to the Icelandic economy in 2016? Well, the first thing they do is basically to ask whether present growth is high or low compared to some measure of what is the long-term growth rate for the economy and this essentially is just assumed to be some measure of the historical average growth rate. Or said in another way if the present growth rate is above the historical average then the economist will “forecast” that growth will slow in the next 1-2 years back toward the historical average.
The “forecast” for inflation will typically be done in the same way maybe adjusting for whether the central bank has a target for inflation – for example 2%.
Obviously if a shock just hit – for example that Sedlabanki had hiked interest rates dramatically then the economist would try to take this into account, but the general rule is one of “mean-reversion”.
And this is in fact not a bad forecasting strategy or rather it is the only thing the economist can do and I personally have no problem with that. However, the problem is that economists are not too eager reminding people that this is in fact the way they do forecasting.
Set up prediction markets
So should we stop listening to economists? I certainly don’t think so, but we should also remember the joke that god invented economists to make meteorologists look good!
We are not better at forecasting Icelandic growth in 2016 than meteorologists are at forecasting the Icelandic weather in the Summer of 2016.
I, however, think that there is something else we could do. We could listen to the “wisdom of the crowds”. That is we could set-up so-called “prediction markets”. That is essentially betting markets, where you can bet on for example what real GDP growth will be in the third quarter of 2016. I have no clue what that number will be, but if there was a prediction market for Icelandic GDP in Q3 2016 I am sure it would be a better forecast that any forecast I could come up with.
Happy New Year!