Andy Haldane, the outstanding chief economist of the Bank of England, has admitted that the Bank got its Brexit forecasts wrong. As he has put it, the Bank's models could not adequately handle the irrational behaviour of people and so failed to predict appropriately what might happen after Brexit. To put it another way, the Bank forecast an immediate downturn after Brexit because it assumed that people would realise all the risks that this course of action entailed. And that downturn did not happen either because people did not think there were such risks, even if the Bank did or, as likely, they ignored them.
The admission is interesting. It's as significant as the admission some years ago from Adair Turner that the Bank of England had, when modelling the economy before 2008 assumed there was only risk, to which probabilistic outcomes could be attached, when in fact there was substantial uncertainty, which is another way of saying no one has a clue what might happen and so could attach no probability to it at all. Turner's admission said that the pure neo-classical view of economics was wrong because rational management of risk based on perfect current perception of the consequences of current action on future earnings is at the heart of that view.
Haldane's admission on the other hand appears to admit that the neo-Keynesian view that such understanding can exist, but takes time to form, is also wrong. The Bank may well be right to believe that Brexit will adversely impact future earnings in the UK. I think they are. But the reality is that this perception is not widely shared. As a result people have refused to behave as if a downturn is coming. Based on the evidence this may be irrational, but that's what is happening. Quite simply the view that the Bank expected to form has not materialised. Either adaptations take much longer than neo-Keynesians think, or maybe they just don't happen. This leads to three possible economic conclusions.
The first is the glaringly obvious one. This is that people do not know what will happen in the future. It's hard enough for most people to work out what is happening around them now. In that case they live now and accept that the future is unknown to them: it is simply uncertain and does not involve quantifiable risk. This means that they will react only when events happen and not in anticipation of them. This behaviour is completely contrary to almost all forms of economic modelling that assumes that current well being is the discounted consequence of future actions. The necessity for economists is to realise that their models just do not reflect not how people are. And economists also need to accept that people are not being irrational in behaving like this. When there is only uncertainty as far as most people are concerned because they have little or no control over the future and so cannot know, let alone impact, the risks inherent in it then discounting it altogether and working on the basis of the only reliable information that they have, which is from the present and past, is rational. Economists need to change the model, and not label people as as irrational.
Second, no economic model that assumes there is a long term equilibrium state to which we aspire makes sense. And nor is it a reasonable basis for forecasting. There is no equilibrium. There are always disruptions. There will always be new understandings that alter desired outcomes. And so there will always be change. The assumption that is implicit in most macro-economic modelling that there is a stable state for the economy and that the art of economic management is in learning how to restore the real economy to that state is just wrong. There is no such nirvana. We live in a dynamic world. And real people know that. They think that things will work out because by and large they always have. And that assumption is rational, and based on fact. Of course things can and do go badly wrong. But usually we recover and life goes on. It may never do so in the way it did before but that does not matter. Through a process of adaptation and change that is quite unpredictable as to outcome life continues. The error then is, again, in the economist's modelling. The assumption that there is a 'normal' state to which we will return, which has been such a theme of post-crash economic dialogue, is just wrong. We won't. We can, and we should, go somewhere else now. Economists who think otherwise are deluding themselves as to the nature of the real world. They're the irrational ones as a result.
Third, what this says is that those elements of populist sentiment that reject activity based on economist's assumptions are right. Financial markets aren't trusted because they produce irrational outcomes (FTSE 100 highs when it is obvious the economy is in trouble) and are rightly dismissed by most people as delivering false messages. Those markets do think they work on the basis of discounting future earnings because that's what the economists have taught them to do. But most people know you can't do that. They know that these calculations can't be based on risk because they are in fact inherently uncertain. And that is why they also don't trust global companies that base such a large part of their earnings on trying to capture today the consequence of future transactions, whether by M&A profits or by financial engineering. Implicitly people know these activities, the rewards paid for them, and the profits that are declared by them are all unreal, using that word in various ways. They appreciate what economists don't, and that is that all this complexity is faux: value is not made by discounting the future. Value is made by doing the right thing now in the light of the uncertainties that we face which we may not be able to quantify but which we believe to be real. And when economists begin to appreciate that we may get better economics.
We have to hope.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
Great post Richard. Thanks.
Thanks
Not what I expected to write when I woke up either
Very much seconded!
Hi Richard, great article, you must have read Prof. Steve Keen’s book “Debunking Economics” ! Happy New Year
I have
What an outstanding piece of writing. Well done.
Thanks
Excellent article! I’m sure you are right that the general public mood will not change unless something materially changes for them. Presumably an increase in interest rates would be a worry, servicing increasing debt with decreasing income would have an effect. Similarly an increase in taxation (income or VAT) that hits people quickly would have such an effect.
What would be your key areas that could produce short-term stress for the general public?
I did a list yesterday
Can you share that list with us all?
It’s on the blog yesterday
Richard,
Finally understanding that people don’t act in a rational way was one of the wake up calls for me.
After years of expecting people to do what makes sense and becoming frustrated when they did something different understanding at least some of the reasons why certainly helped.
I find Dan Ariely, someone who explains some of the concepts and why people do things you don’t expect in terms even I can understand, worth reading. Link to one of his videos below.
https://www.youtube.com/watch?v=ywanX0GL-1U
Thanks
So Hayek’s “Pretence of Knowedge” is in evidence, do you think? If so, is his conclusion valid? That the State cannot adequately plan for its citizens and should stop trying.
I was sure I had answered this but it has popped up again
No his conclusion is not valid. Too stop planning because of uncertainty would be lunacy. Despite it most of us will get up tomorrow morning. Of course we should anticipate that.
The whole paradox of living successfully is in fact planning for a future when we know we might not have it. Hayek did not realise that
Sorry – I’m not fully familiar with your back catalogue so if you have answered this before I’ve missed it. I do visit, but not regularly.
To continue – yes, people should plan for an uncertain future, but isn’t that best done for the individual and their families? Now we can see that the aggregation of data doesn’t lead to good information for the State, how can the State conceivably be able to plan for the best overall good?
I’ll confess – I have never been a fan of the concept of central planning but after these revelations I wonder how can you still be? You repeatedly criticise the politicians of all stripes, yet still maintain that the State (directed by politicians) is best placed to plan for us all. How can this be so?
Hayek’s point was that if WE OURSELVES can’t know enough about the future to plan adequately even at the individual level – how much LESS able is the State to do it for us? Surely today’s admissions support that?
A long time ago it was realised that there was no merit in each person planning for their own household fire, the risk of which was low
But there was enormous beenfit in communities planning for the outbreak of a household fire somewhere, the likelihood of which was high
It appears you have not learned that lesson
For Geoff Taylor:
Regarding Hayek, let is not forget and consider that this was a man who was severely influenced by what he saw happen in Germany (and Austria eventually) under the Nazi regime.
After witnessing the Nazi machine at work (its statecraft), it is not surprising that Hayek saw any form of state planning or organisation at all as essentially evil and something to at least be wary of.
What seems to be ignored is that Hayek’s reaction – although in many ways justified – is in itself as EXTREME reaction to the extremes he saw in the Nazi regime as he seems to want to negate nearly all state activity as a result.
This is just plain silly to be honest as it points the finger at all states as being like the Nazis state. This is simply not true. Yes, States do things that are questionable in the name of the people but not all of them ended up like Nazi Germany.
What is also telling is how the resulting Hayek influenced/Friedman neo-liberalism actually enabled states like Pinochet’s Chile to exist for example as well as the atrocities that took place throughout the rest of South America because of neo-liberal meddling by the Chicago School.
These terror states sponsored and supported by the CIA (also seen in Africa) were all based on powerful individuals (whom Hayek sees as better, more moral planners) undermining their own states and running them as a front for vested foreign interests (usually the USA and its corporations)and getting paid handsomely for their connivance.
On entrepreneurialism, Hayek insisted that only individuals could behave like this. The cancerous effect this thinking has had on the lack of innovation in say the public sector and public policy can not be underestimated. Hayek also ignored observed and known human behaviour such as altruism in the formulation of his ‘theories’. The propensity for neo-liberals to over simplify reality and make false claims backing their revision of it is now surely well known. I too would recommend that you read Steve Keens book ‘Debunking Economics’.
For me, the modern history of South America and Africa completely repudiates Hayek’s one eyed, jaundiced view of the State and the supposed supremacy of individualism. To me he is thoroughly discredited. As is Milton Friedman for that matter.
Thanks PSR
Shall we ask Hayek’s ‘man on the spot’ to solve the problem of global warming?
Humankind needs organisation structures, and as the World because more complex and more global only large structures has any chance of success.
Hayek didn’t realise that either. In fact his fame only survives because of his popularity amongst free-market political ideologues.
I thought Hayek’s fame persists because he won one of those Nobel Prizes that Mr Murphy was pining over earlier today. But, hey ho, revisionism seems to be in fashion so please continue with your untruth.
We have just seen, before our eyes, a significant admission that a very large structure (UK Treasury) has been badly misled by the data it received. This is not the first time, so why should we still discount Hayek’s assertions out of hand?
I note, sadly, that I no longer have any option to reply to Richard’s comments. If I did, I would ask him about the limits of “community”. A village of a few hundred is not a town of a few thousand which is not a country of tens of millions – the community principle has a limit, does it not? Town planners can at least have a realistic chance of identifying risks (houses on the flood plain, knowing the local scrotes, which schools are under capacity pressures) – surely national planners have no such sensitivity. Surely?
You did have the option to reply
But you lose it when you are rude to others here
You also lose it for posting nonsense
For two reasons your timer here is up
Excellent article Richard.
When will the Labour Party get it?
I notice that none of the media who reported this ‘michael fish’ moment bothered to talk to any of the economists who did predict the crash (Anne Pettifor, Steve Keene for example)
Me! I was a Green New Deal co-author and we got it right
If only they had listened to your predictions in A New Green Deal we could have avoided it all! Northern Rock, bank bailouts, the lot.
Will they listen to you now, I wonder?
I doubt it
But I’l still keep saying it
Excellent and thought provoking. My thinking is that people do spend less if they have less confidence, but confidence is already knocked and no-one trusts the experts these days. Slightly tongue in cheek and I am far from a fan of Gove but i understood the sentiments he was putting there. The failure of the economic models feed into this distrust. I really like the concept of constant change/lack of equilibrium.
It’s like a moving average with no predictive qualities
Great piece! I also do not like the irrational label – I prefer to think people as rationally random. On the basis of incomplete information, the rational thing to do is to use heuristics and choose one of the possibilities at random with a preference for the easiest route which is probably to carry on as before, until there is hard evidence to suggest a change is necessary (better to stick in the face of uncertainty). As you say this builds in a time lag.
Haldene is a deep thinker, understands the need to change economics, has written about the latest ideas on rationality – the Kahneman – Gigerenzer debates on Bayesian vs. heuristics or both etc. and is actively working on heterogeneous heuristic agents based models. We need more people like him in the mainstream.
Steve Keen always says that physicists just laugh when they hear that economists assume equilibrium – I couldn’t possibly comment 😉
If I ever meet an economist I always ask: What is equilibrium income share of the top 1%, why do we never seem to get there, and why are they not talking about it?
The correct physics term for the economy is a driven-dissipative non-equilibrium system which is a bit of a mouthful but it means that there is driving (inputs: energy, labour, resources, etc) and losses (energy dissipative, consumption, etc.). There is also a lot of uncertainty. Counter to the popular view, that is also true in statistical (many-body) physics too.
Don’t tell economists about physics post 1927. They don’t want to know about it
Heuristics are essential to survival
And are also the basis for all expertise
The best heuristic of all is knowing which heuristic model to use
Quantum Economics is the thing. Must be a Nobel Prize in it somewhere
Hi Richard, nice article! I wonder about your views on a couple of details:
1. Do you think there is a distinction in this modelling between “people” and “businesses”? In particular, have (larger) companies, with economics-respecting planning departments, not acted in a more risk-averse way since the Brexit vote? (Not all have received whatever direct assurance Nissan did.) While I appreciate the sentiment of the piece, I wonder if the detailed implications for economic modelling are more in shades of grey.
2. The reporting of Haldane’s comments seems to have been a straightforward “they were wrong”, but the Bank *did* cut interest rates and start a new QE programme, and the Chancellor did declare an effective mothballing of austerity (I’m not sure what has happened in concrete terms, but even the indication of more openness to public spending could have influence on behaviour). Do these economic adjustments not largely invalidate the criticisms? I interpreted his statement as partly being an attempt to regain control of the narrative… no?
Thanks for any insights.
Re (1) you are right: large business is more akin to the models economists may use – which is why economists believe they are right
Re (2): the reporting has been dire. But the question does arise as to why the Bank did not forecast the impact of its own behaviour. Surely that was within the boundaries of possibility?
Richard – you certainly got out of the right side of bed on Friday morning! Firing on all cylinders…
In mentioning the great work of people like Andy Haldane and Steve Keen (and there are of course others), perhaps you are illustrating a trap that we may be falling into by talking about and dismissing ‘economists’ in general. A trap that perfectly suits the Brexit/Trump/Gove/et al gang as it fits with their dismissal of all experts and economists in particular. We know that there are some great economists out there who amongst other things, recognise the need for heterodox ideas, understand the need to build in uncertainty and complexity, are deeply critical of the narrow thinking of the neo-liberal orthodoxy and its reliance on profoundly flawed models. Their ideas and thinking are crucial to getting out of the mess we are in. We need their expertise and so do the politicians and policy makers
So maybe we need to find a way of being much more selective when talking about economics and economists. Challenging those who are still wedded to those narrow orthodoxies and pointing out where there are politicians who are still pretty much wedded to the same orthodoxies. Vigorously promoting the Haldanes, Wren-Lewises, Keens, Coppolas and others to make it clear that they have a lot to contribute. Haldane is probably their public face at the moment. Do we need new labels and language to describe the old and new economics in plain English? Neo-liberal and heterodox does not mean much to most people.
Robin
You are right
Except I tend to think of those who think appropriately T as political economists
Remember we started as moral philosophers
Hard to recall
Richard
I take your point. But perhaps ‘political’ might not be the best label given that politicians have an even worse reputation than economists!