If economists were seismologists, they would be in jail

Investors are bombarded with data everyday in the stock market.
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First Published: Wed, Jan 23 2013. 08 32 PM IST
Jayachandran/Mint
Jayachandran/Mint
In October 2012, an Italian court convicted seven earthquake experts for manslaughter for failing to give adequate warning of a quake in 2009 that killed at least 300 people. Nothing compares with the tragic loss of human life, but should analysts, experts and policymakers in the field of economics and finance also be held accountable for making wrong calls, or for that matter not taking a call at all, as it could lead to human misery? If that was the case, we would have a long list of accused who misread the moves of the market and the economy.
The human ability to foresee the future remains as questionable as ever. This was recently exposed as the shares of Infosys Ltd shot up 17% after the firm reported numbers for the third quarter at a time when most analysts tracking the stock had a sell call. Mint’s Lisa Pallavi Barbora on Monday captured how none of the analysts saw this coming and are now busy changing their recommendations (http://bit.ly/WxCZ3I).
If you are willing to accept this failure of market experts in anticipating the movement of Infosys as a one-off incident, think again. Michael Patterson and Lu Wang of Bloomberg in a recent article noted how most of the heavyweights got it wrong in 2012. John Paulson who manages $19 billion in hedge funds, predicted that the euro will collapse; Morgan Stanley predicted that Standard & Poor’s 500 would lose 7%; and Credit Suisse Group AG was of the view that equity prices will see wider swings. But nothing of the sort happened. The euro survived and markets went up all over the world.
This is not the first time and certainly not the last time when celebrated experts have gone terribly wrong. Economist Irving Fisher who led the way for research in monetary economics (in)famously predicted just days before the great crash of 1929: “Stock prices have reached what looks like a permanently high plateau.” Two Nobel laureates in economics, Robert C. Merton and Myron S. Scholes, could not foresee the risk Long-Term Capital Management Lp, the hedge fund in which both were on board, was exposed to, and the fund eventually had to be rescued in 1998.
Further, at a time when economists and central bankers were busy celebrating their victory on business cycles, the world was hit by the worst financial and economic crisis in 75 years. Economists and policymakers, barring a small minority, were caught completely unawares. In fact, Alan Greenspan, then celebrated chairman of the US Federal Reserve, talking about real estate prices in October 2004, said: “While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the US, given its size and diversity.” In response, Paul Krugman in an August 2005 column in The New York Times noted: “There’s a rough ride ahead for the US economy. And it’s partly Mr Greenspan’s fault.” Thus, there is no shortage of instances in history, where experts individually or collectively failed to foresee the future.
But the question is why do experts go wrong so often, or to be politically correct, why are they not correct all the time. Again, keeping tragic incidents such as earthquakes aside, is making sense of the market and economy so difficult. Yes, it is. There is no way that anyone having a PhD in quantum or particle physics—degrees in fashion on the Wall Street—could have predicted what the European Central Bank and the Federal Reserve would do during the course of 2012 and how it will affect the market.
Interestingly, Nassim Nicholas Taleb in his book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets makes a case that people tend to underestimate the role of chance. Future projections are simply based on facts from the past and, maybe, that is not sufficient for peeking into the future. Taleb notes: “The problem is that we read too much into shallow recent history, with statements like ‘this has never happened before’…history teaches us that things that never happened before do happen.”
So the question is why do people make projections when they are difficult, and often incorrect, in the first place. The answer is relatively simple: because there is demand. As long as people want to know their future, there will be astrologers. It is simple demand and supply economics. If people want to know what will happen to the market or the economy, they will find someone willing to give that forecast. Therefore, despite the spectacular failure of the entire profession in foreseeing the financial crisis, economists continue to be in demand.
End note: The idea is not to undermine the relevance of knowledge and understanding in this complex world, but it is also true that despite all the ifs and buts in place, there is a chance that things can go wrong. We still have to learn to account for the risk of unknown. The problem is more acute in the stock market where investors are bombarded with data every day. But it may be better to make investing slightly boring and basic. You don’t have to find a new stock every day, or every month; you have to find 10-15 good stocks over a period of time and hold it for a long period. There is no guarantee that you will end up making money, but this strategy, arguably, has been successful in the past. Remember we still have to rely on the past to move forward. Infosys analysts have just confirmed that.
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First Published: Wed, Jan 23 2013. 08 32 PM IST
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