The global financial crisis is a bit like one of those traffic jams that you encounter on summer holidays - one minute you are motoring along nicely and the next thing you know things have ground to a halt. As you are crawling along you notice a lot of uncertainty on the faces of others. After a while things seem to speed up again and then, before you know it, you are back up to full speed and speculating about the cause of the slow down.
Just like traffic, economies slow down or even grind to a halt from time to time. Sometimes the causes are obvious, like a broken down car blocking a lane or a housing market based on selling houses to people who could never afford to buy them. But usually, the causes are a mystery.
But unlike an inexplicable traffic delay, when the Australian economy slows abruptly there is no end of forecasters, commentators and superannuation providers who can be called upon to offer predictions, often involving a number of decimal places, about the likely depth, length and sectoral composition of the downturn.
There is no doubt that an understanding of how the economy works, in theory and in practice, can help provide a broad framework for interpreting current events and suggesting more and less likely future outcomes. But there is also no doubt that no economist, or group of economists, has anything like a crystal ball that can foretell the future. In fact, most economists would admit that they don’t even have a very good rear view mirror to help describe what has already happened.
So next time you hear someone on the radio stating with confidence what has happened, is happening, or will happen next in the economy, here are a few things to keep in mind.
First, never confuse precision with accuracy. The fact that someone is forecasting the rate of growth or inflation in 12 months time to one or more decimal places should, under no circumstances, be seen as evidence that they must have a good idea what is going to happen. The opposite is more likely to be the case. No economist really believes they know to the decimal place what is going to happen in 12 months time and you would probably be better off giving more weight to forecasters who say things like, “I think growth will be faster next year”, than to one who says, “Growth will be 3.92 per cent next year”.
Second, when you hear someone talk about what their “macroeconomic model” predicts, it is probably best just to smile politely and back away. While such models have a role to play when used modestly by sensible people, when they wind up in the wrong hands things can get ugly. The main thing to know about these models is that they don’t forecast what will happen next year, they “project” what would happen next year if nothing unexpected happens. In a nutshell, what these models usually tell you is that if nothing much changes then things should be pretty similar next year. Most people don’t need a model to know that.
Third, if a model failed to predict the dot.com bubble, the Asian financial crisis or the global financial crisis, why would you pay too much attention to what those same models have to say about when the economy will recover or whether things will get worse before they get better?
Despite their inaccuracy, economic models, and the forecasts they produce, play a number of important roles including providing a bridge between the insatiable desire of people to know what is going to happen and the unavoidable truth that such knowledge does not exist.
But no matter how much people wish that economists could tell them with certainty what will happen next they will never be able to do so. What economists can do is speculate, based on past relationships or international experience, how certain events might unfold or how policies may affect the Australian economy. But like commentators talking about the next cricket test or passengers in a car speculating about which road will be less congested at a particular time of day, no honest economist would state with certainty what will happen next year to two decimal places.
There is no certainty or precision in this world, and, at least for things as interesting and complex as our societies and economies, there never will be. But we don’t need to know what the temperature will be in 70 years time, or even what the exchange rate will be in 70 days time, to make good decisions.
In the absence of a crystal ball the best strategy is to base spending decisions on what you can afford. Borrowing large amounts of money based on forecast increases in share prices, house prices or gold prices might make you a lot of money, but so too might a bet on the favourite in the Melbourne Cup. Global financial crisis or not, betting more than you can afford to lose will always be a risky venture, and if the forecasters are so smart, why are they still working for a living?