Chaos Trashes Economic Predictions

The economy is what mathematicians call a chaotic system, in spite of what most economists have assumed since the dawn of time. Because it is, forecasts beyond the near future are inherently meaningless. It’s not that our tools need to improve, it’s that reliable forecasting over longer periods is impossible because of the nature of chaotic systems.

Most theories of economics have relied on assumptions that are untenable, in my opinion. We have assumed that there is something called market equilibrium, and that all market activity trends toward a sort of benign balance. We also assume that markets are efficient, and that everyone has complete information to make market decisions, etc. Today the only ones who buy such assumptions are those who believe the Free Market is actually free. My belief is that there is no such thing as a Free Market; it is always tilted to benefit those with the most power and money.

All economic theories I’ve heard of fail to account for greed, which we have observed in full flower in recent years. Is there any conceivable reason a hedge fund manager should be earning a million dollars an hour, when the average annual income is about $50K and millions don’t earn half that? Such outlandish gains are largely stolen from the common purse, and in the case of hedge funds, contribute nothing to the common good. Nor do theories adequately explain the effects of globalization. And they certainly don’t take into account our ongoing destruction of our environmental life support system, which could within decades create a planetary upheaval that could only be called catastrophic.

The essential feature of chaos, including economic chaos, is that every element can be changed by other elements. In economics, an element might be a neighborhood coffee shop, for example. When an element is affected by another element, it assumes a new status, which may be better or worse, or simply different. This recurs continually for every element. Each newly changed element affects several other elements, and those do the same.

Elements of an economic system are changed,
and in turn change other elements.

If a neighborhood business fails, for example, the neighborhood coffee shop may become less profitable. If the business is diminished, its owners will order less coffee from their suppliers. The suppliers, now, are affected, and they, in turn, may find it necessary to change their own purchasing, although we don’t know how they will change until we find the total effect of all elements on the coffee supplier. And numerous other factors will influence the shop, the supplier, and the customers.

So we have arrived at a later point in time, a day or a week later, perhaps, where one entity has changed, and has in turn changed other entities, which will change others. All that involves only a few businesses. But the economy doesn’t consist of just a few businesses. There are many such actors even within a rather limited area, and millions over larger areas. Each of them might affect several others to greater or lesser degree, for good or for bad. By the time later iterations of these affects happen, say after half a dozen moments of change, the possibilities for the status of the economy or any part of it are virtually infinite. We can and do make predictions that are sometimes right if nothing noteworthy changes, but we cannot account for “black swan” events that change everything, any more than we can account for the infinite possibilities that arise, and that is why reliable longer forecasts are impossible.

Just a few periods of change
bring infinite, chaotic possibilities.

If the actual condition of any element of the economy is even slightly different from what we thought when we began our analysis, completely different outcomes are not only possible, but highly likely. So, for example, an initial difference of even 1% in a mortgage interest rate may have outsized positive or negative effects on the housing market rather, and on the economy as a whole after even a limited passage of time. And in many cases we can only guess at the initial state. A successful forecast over an extended period is therefore mostly luck, since anything even slightly unexpected could knock it into a cocked hat.

In that way it is very much like weather forecasting. Meteorologists have been very successful with local weather forecasting for periods up to five days by using millions of data points in supercomputer systems. Beyond that, the system becomes so chaotic that it is literally impossible to make meaningful projections. It will always be that way. It is not the tools meteorologists use that force this limitation, it is the chaotic nature of the weather itself.

Long term predictions in economics are meaningless,
because economics is a chaotic system.

Likewise, the economy is unpredictable beyond a limited time period, and it is hypersensitive to minor differences in an initial state. If someone predicts a future economic status with assurance, he is projecting based on standard statistics—the bell curve and standard distributions. But the economy can’t be squeezed onto the bell curve. Measurements that slide off the tails of the bell curve can happen when they shouldn’t, and the unexpected can be expected at some unexpected point in time. No one predicted the 2007 crash much before it happened, nor any of those that preceded it, because no one could. Nor will anyone predict the next crash. Long term projections have little or no meaning or validity in chaotic systems.

We should accept this and quit expecting economic forecasts to be accurate. Rather, we should strive to make our personal and national economies “antifragile”, as Nassim Nicholas Taleb argues in his latest book, Antifragile. The 2008 crash was so devastating because we were fragile, with high debt, low savings, and a housing bubble. By building semi-immunity, we will not be so devastated by the inherently unknowable future market crashes.

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Published in: on 2013/03/27 at 8:02 pm  Comments (1)  
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  1. And you haven’t even touched on the fact that macro- and micro-economics are two largely independent systems of thought. Actions that might be good in one might be disastrous in another. (Talk about chaos?)
    Also, traditional economics assumes rational decisions based on full and open information. In reality, emotions and beliefs play a large role in the decision-making, and as you point out, the available information is limited, at best. A five-day weather forecast may be optimistic.
    At least from the perspective of personal finance, some of the most useful insights I’ve encountered have come from psychotherapists, poets, and religious traditions, rather than bankers and investment brokers. I’m putting some of that material up at Chicken Farmer I Still Love You (frugaljnana.wordpress.com) for anyone who wants to join the dialogue.
    Best wishes in stirring the pot.

    Like


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