WASHINGTON, Jan. 8, 2016 – “So why has the market gone ‘splat!’ this week? Is it China?”
My wife’s question is the one other friends have asked, and it seems to have replaced the ever-popular, “what do you think will happen to interest rates?” as the most popular question to ask economists this week.
My usual response to questions like this is, “if I understood markets well enough to predict them, I’d be talking to you by phone from the beach of my private island. If I bothered to take your calls.”
Economists aren’t entirely ignorant of the forces that move markets. We no longer believe that they’re controlled by spirits, nor do we attempt to propitiate those spirits with virgin sacrifices. When we attempt to predict markets, however, we might as well festoon ourselves with feathers and chicken blood and rattle strings of bones.
We do something along those lines, but we call it “econometrics.”
We construct elaborate mathematical and statistical models, we feed them reams of data, and then we announce to the world, “we expect economic growth this year to be 3 percent.” We’ve been predicting 3-percent growth for years, now, and eventually we’ll be able to say, “see, we told you so.”
If we predict that you’ll recover from a headache, we’ll almost certainly be correct, as long as we avoid predicting the day and the hour. If we predict that you’ll die, we’ll eventually be hailed as prophets – in the long run.
Otherwise, our models are mostly good at predicting the past. Almost any economics grad student can construct an econometric model that will predict the past with near 100-percent accuracy.
The problem isn’t that our models are useless nonsense. They aren’t. But they do rest on assumptions so demanding and precise, both about the behavior of the real world and about the quality of our data, that our actual implementation of them is like trying to build a fine Swiss watch with scrap from a junkyard and a blacksmith’s tools.
If we can’t predict the future any better than climate and weather forecasters (here are a couple of tips for you: July will be warmer in Boise than January is; and if carbon dioxide levels keep rising until they match oxygen levels in our atmosphere, earth will be a furnace and everything will die), can we at least explain what’s going on now?
Yes, certainly. The Fed’s interest-rate hike makes dollar investments more attractive to European investors, who face low-to-negative interest rates in euro- and Swiss franc-denominated government bonds. Thus we see upward pressure on American stock prices.
Oh, umm, well. That of course is all else held constant, and nothing else is ever constant. We must take into account what’s happening in the Chinese economy. No, not their stock market – a rigged casino if ever there was one – but in their real economy, which isn’t doing as well as the rest of the world had hoped, let alone China’s leaders and panicky investors.
You might accuse me now of being facetious. Economists aren’t really that clueless or duplicitous, are we? No, we’re not. The comparison to weather and climate forecasters is a fair one. We know what some of the important forces are that guide economies in the long run. We know how many parts of the economic system work, and we know how some of them interact.
We know that America’s debt will eventually have to be paid, either by raising taxes or by the “inflation tax.” We know that, unless an asteroid hits, the global economy will continue to expand and create new industries, products and jobs.
We know how to measure some of these things, and we know the most likely eventual outcomes of a wide variety of policy options.
We just don’t know the day and the hour, and we don’t know how to predict economic asteroids. Our models aren’t as naïve as many of our critics claim; we aren’t dependent on the notion that people will always act as rational, economic decision-makers, for instance, or that they only care about money, income, profits or their own utility. We know that people aren’t like atoms, even on average.
Imagine a chemist having to ask a tank of chlorine before an experiment, “are you really chlorine?”
“Oh, no,” the atoms respond. “We’re really argon. Try us, you’ll see!”
People are perverse and fickle, and when they know you’re watching them, they aren’t themselves, or they change their behavior. We know that. Don’t accuse us of assuming that they’ll be rational today, tomorrow and forever.
And don’t accuse us of thinking people are always greedy or self-interested. People are often generous and kind, though not as often as they like to think they are.
Our models are complex and incomplete, but improving. I can’t tell my wife with absolute certainty why the stock market has gone “splat” this week, but I can concoct a reasonable story that has a good chance of being partly true. I can make an educated guess about where the economy is going, just not with enough precision and certainty that I’ll ever own my own Caribbean island.
And I can assure her, the world will continue to be a volatile, unpredictable place and don’t believe anyone who tells you otherwise.
There are a lot of things to worry about in this world: your kids, your food, your health, random violence, fire, war and asteroids. Add in your financial situation and retirement, and that’s too much worry. Take prudent measures to protect yourself from the things you can predict: Make your kids read some books; brush your teeth; eat some vegetables once in a while; insure your house; diversify your portfolio.
Then don’t worry. Someday something will kill you anyway. The best we can get from life is to be happy. So pet your dog, love your kids, hug your spouse and stop smoking. Life is fine.