Random economic shocks: There are no rational ways of making accurate long-run predictions

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March 02, 2020 1:15 AM

The fall in stock prices is cautionary, not necessarily calculated; there is no reliable way of calculating. Faced with the unknown, all you can do is to go into cash.

There are appeals for bank lending, and even stock market valuations, to become sophisticated to counter the likely impact of climate change. (Representative image)There are appeals for bank lending, and even stock market valuations, to become sophisticated to counter the likely impact of climate change. (Representative image)

Economics deals with systematic interaction between variables—supply, demand, investment, and consumption. Statistical tools that economists deploy add the idea of random variables—’shocks’—to these variables. Yet, even after nearly a hundred years of the development of econometrics, the treatment of random shocks remains quite naive. Economists overuse the normal distribution—the bell curve—to model the influence of systematic variables, filtering out the random shocks. The logic is that most shocks are small in size, and not too far away from the average prediction. The large shocks are far away from the average, and less and less likely. The measure is standard deviation—sigma. Ninety-five percent of shocks are within two sigmas. QA four or seven sigma shock is extremely unlikely. (Whether one should allow for three sigma risks or something much larger was at the heart of the dispute about RBI’s reserves).

Benoit Mandelbrot, the French mathematician, tried for decades to convince econometricians that the distribution of random variables may be non-normal, involving fractals. He was ignored as either too naive or too sophisticated to be useful, especially for econometric analysis of stock market data, where data are ample. The idea of efficient markets—that markets can absorb all information and help agents make rational decisions—discovered by Eugene Fama prevailed and got him a Nobel Prize.

Now, the global markets face a double challenge. One is the possible effect of climate change on the global economy. There are appeals for bank lending, and even stock market valuations, to become sophisticated to counter the likely impact of climate change. This is quite tricky because the horizon is quite far away, and, as Keynes pointed out long ago, there are no rational ways of making accurate long-run predictions. All an investor can do is rely on ‘animal spirits’ or ‘rules of thumb’. In the 1960s, when the real threat was of nuclear annihilation, one could have argued that economists should factor in the probability of mass destruction into their long-run investment plans. Today, the nuclear threat is totally forgotten, though nuclear devices have proliferated. It is not that anyone is in a nuclear-holocaust-denial mode, but the fear has passed. Anyone who took long range decision to factor in nuclear holocaust must feel like a fool.

Climate change is similarly difficult to deal with. Scientists are more confident of their long-run forecasts, and to challenge them is to be in denial. But, the crucial question is this: If people react to ward off the likely long-run effect of climate change—say by discovering better technology, or altering their habits—does the forecast stay the same, and if not, how is it modified? Should one continuously calibrate investments in light of changing probabilities? Does economics have any rules to guide us, or is it animal spirits?

Take a more immediate problem. Coronavirus is causing nervousness in markets across the world. It has taken a few weeks for the markets to react. To begin with, the idea was that the impact would be confined to slowdown in the Chinese economy—decline in Chinese consumer spending at home and abroad, slowdown in production, etc. There was no serious way of measuring the likely impact, except everyone thought it would be confined to China.

Now that the virus has spread across the world and is continuing (faster than climate change), the markets are worried about the impact on supply chains, employee absence forced by isolation, and decline in travel and tourism. The fall in stock prices is cautionary, not necessarily calculated; there is no reliable way of calculating. Faced with the unknown, all you can do is to go into cash.

This is a classic ‘black swan’. There is no way of forecasting it, nor any accurate way of modelling its spread or longevity. The varying capacities of different health regimes to cope with the viral attack, and the lack of a clear allocation of responsibility for those in transit, means rational calculation of any sort is impossible. Faced with so much uncertainty, the best things monetary policy can do is loosen the purse strings, and lower the interest rates. Fiscal policy is useless as it works, at best, with an annual cycle (tax payments), or with longer lags. Central banks can act faster, and in swift cooperation with one another.

Will there be a recession? Will it be if the size of 2008? My hunch regarding the first question is yes, and regarding the second, unlikely. What I know with much greater certainty is that I am most likely to be wrong.

The author is Prominent economist & Labour peer Views are personal

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