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The Forecasting Business

November 13th, 2012 by Viv

Viv Forbes
Written 1998.

Recently, our farmers and miners (at least the rich or naive ones) gathered at the altar in Canberra to hear the ABARE forecasts for our great primary industries.

They should have stayed at home. They obviously had not heard of a similar conference held by the German Furniture Manufacturers’ Guild in Munich in 1928. To help them plan their future the Germans invited the greatest political prophet in Europe to forecast the conditions they could expect in 5, 15, 20, 40 and 60 years’ time. He gave the five year forecast first.

“In 1933,” said the prophet “Germany will have 5 million unemployed and will be ruled by an unstable dictator using emergency powers and an army of secret police”.

This disturbed the burghers, but they were reassured by his 15 year forecast.

“By 1943, I predict that Munich will be part of a Greater Germany which stretches from the Volga to the Atlantic and from the Arctic to the Sahara.”

While the burghers were still dreaming of the market possibilities of Greater Germany, the prophet went on.

“But in twenty years from now, in 1948, Munich will be part of a tiny German nation that stretches only from the Elbe to the Rhine, whose cities are ruined and whose factory production has been as low as 10% of the 1928 level. An Iron Curtain will stretch across Europe and seventeen million Germans living east of this line will be locked up in a Russian prison”.

The shocked burghers waited in silence for his next forecast.

“In forty years from now, in 1968, the real income per head of Munich will be four times greater than it is now. In the year after that, 90% of German adults will sit looking at a box in the corner of their lounge rooms which shows live pictures of a man walking on the moon.”

The now sceptical listeners waited for his final forecast – “In 60 years from now, the Prussians will knock down their prison walls revealing a nation of incredible decay and destitution.” The burghers called the police and had the prophet locked up as a madman.

My point is this. Forecasting is a very tricky business, and even if you do find a good prophet, you may not find anyone who will believe him.

I have been close to the forecasting business now for about 20 years and one thing I have learned is this – “He who lives by the crystal ball ends up eating ground glass.”

And using a computer does not necessarily improve the accuracy of the forecast.

You’ve all heard, I’m sure, of the computer model used by the Club of Rome back in the 1970’s which predicted the imminent exhaustion of most of the world’s resources.

Some wag took that model and fed into it the energy and resource data available in 1850. The model predicted that by 1920, the streets of New York would be 10 feet deep in horse manure. This is a variation of the computer slogan – Garbage in – horse manure out. Similar computer models are now forecasting that greenhouse gases are about to suffocate the earth. What the horse manure model ignored was an eccentric individual named Henry Ford playing with an engine in a tin shed in Detroit. The foresight and drive of this individual made garbage of all previous forecasts. So did the discovery of the machine gun, atomic power and the wonder drugs, the watersheds of the Black Death and the Wall Street crash, the rise and fall of fascism and its blood brother, communism, and the cascading power of the computer. What the past teaches us is that no one individual or group can consistently predict the future. Nature is full of secrets and surprises and open societies are constantly searching for improvement and innovation. While our system is left free to explore and innovate it will continue to confound the forecasters. Nor should we be too concerned about that. Too many people have accepted the view that “uncertainty” always brings problems. “Uncertainty” is a two-sided coin. One side reads “Problems” but the other side reads “Opportunities”. This is why uncertainty provides the necessary incentive to innovate. It excites both the fear of failure and the desire for success – both are effective spurs to exploration and innovation. Economic uncertainty arises because people have options. It is maximised where people can choose whether or not to buy or sell, whether to invest or consume, whether to work or retire. Freedom of choice for consumers translates into uncertainty for producers and vice versa. That is why richer nations suffer more booms and busts than poor countries.

Uncertainty is the entry fee into the rich world. If you are sitting in a gutter in Calcutta, neither a boom on Wall Street nor a slump in Tokyo will greatly affect your spending or investment decisions. There will be little economic fluctuation in such a society (or in jail, another safe and secure place). But if you’re a rich American, even a scary editorial in The Wall Street Journal may cause you to postpone discretionary spending and thus create uncertainty for sellers of those products.

Economic forecasters have a bad name because the profession has been infiltrated by two breeds of charlatans. The first is the politician with a secret agenda. The other is the mathematician with a computer. These two are the dangerous breeds of the “homo economicus”. Neither understands that economics is the result of human action. Human action does not conform to the wishes of coercive utopians – individuals and groups act in their own self-interest as they perceive it. Human action also continues to confound the unchanging computer formulae of the econometricians, because humans learn from their most recent mistake, and generally don’t repeat it (but they often repeat their grandfather’s mistakes).

The political-economist is perhaps the least dangerous, once you learn to recognise him. He was infected by the Marxist bug long ago, and although Marxism is dead in the Marxist heartlands, he still sees everything through a Marxist Mist of Muddled Ideas. He has concern for all the good causes and is annoyed by the stupidity of political and business leaders (compared to him, of course). He believes that if only people would put him in charge, he would organise a better, fairer and more efficient world. He is a totalitarian at heart and sees the world not as it is, but as he would like it to be. His forecasts and prescriptions are based not on economic laws, but on his desire to change things according to his values and goals. He uses and creates “crises” to promote his unchanging agenda – the energy crisis, the monetary crisis, the environment, drugs, land rights – all are merely useful vehicles for his propaganda. Once you recognise him, you can dismiss him and treat his forecasts as just one more political wish list.

The other dangerous forecaster is the econometrician with the black box. He believes that the huge complex web of human action created by thousands of producers and sellers and millions of products and consumers, all with individual goals, unstable emotions and their own standards of value, can be reduced to unchanging equations in his computer. He is also a great believer in aggregates and averages – for example, if you were forced to sit with one foot in boiling water and the other in a bucket of crushed ice, he would rate you “Comfortable, on average.”

An econometrician is more useful than a political economist, but you must know what questions he is able to answer. Suppose you ask him “If the price of steel in Australia rises by $100 per tonne, and nothing else changes, what will happen to the domestic demand for steel?” – He can probably give you a useful answer to this question.

His computer has a monstrous memory, a colossal computing ability, but no brains at all. If you put assumptions in, it will give the answers likely to result from those assumptions. But it can’t tell you whether or not the assumptions are sensible, and it cannot make all the assumptions for itself. (“Garbage in, Horse Manure out”). His model cannot predict the price of steel unless it is provided with other assumptions. To get a correct forecast needs accurate assumptions, a realistic model, and no change in behaviour by those perverse and unstable humans who make economic choices.

So my advice is to trust no econometrician till you have watched him for ten years. By then the temptation will have passed. Your business strategy should not depend on the accuracy of any of his forecasts.

The 1998 ABARE conference was dominated by learned discussion of the Asian Crisis. I can’t remember it being mentioned at last year’s conference.

Thus, my advice to farmers and miners is “The next time government organises an economic outlook conference, go fishing.”

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