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Nov 03, 2015

Predictive Economics: A Guise for Snake Oil

Christina Siegel Malbon

Recent market volatility and economic worries have people clamoring for clarity, demanding answers from experts. With the rise of Internet and financial TV, experts are constantly offering advice and predictions to anyone who will listen. Heeding the advice of an expert can bring comfort in a world rife with uncertainty; however, that comfort is not without cost. In Deirdre McCloskey’s short book, If You’re So Smart: The Narrative of Economic Expertise, she tackles the risks inherent in following the advice of expert economists. McCloskey equates the economic expert on TV to a traveling “snake oil salesman” selling wares of economic predictions and policy advice.

McCloskey contends, and rightly so, that economics is not a predictive science. While experts can intelligently reflect on the past and critically analyze the present, they cannot profitably predict the future. Be wary of the economist who claims to know where interest rates are headed, says McCloskey, for “if they are so smart, why aren’t they rich?” If the expert was able to accurately and consistently forecast bond prices (or other capital market prices), that information would not be offered for free on financial news programs, but instead acted on to create wealth. A useful contrast to those experts who appear on financial channels is that of Ed Thorp, author of Beat the Dealer, the book that showed card counting could provide a profitable edge in blackjack. Thorp later turned his attention to Wall Street, discovering previously unrecognized patterns in the pricing of derivative securities which he kept to himself and used to build a considerable fortune.

The expert’s failures in forecasting are the result of economic theory’s shortcomings in its predictive ability. In Part II: The Shifting Paradigm, Bill postulates that economics is a primitive science. Building financial models on economic theories lacking efficacy in the real world is akin to buying “snake oil” to assuage an ailment it surely cannot.

Instead, McCloskey suggests that the strength of economics lies in its ability to provide analysis of the present inferred from stories told of the past. To do this, an expert must use what McCloskey calls the Rhetorical Tetrad: facts, logic, metaphors and stories. While economists might argue that their science is limited to only facts and logic, McCloskey points out that stories and metaphors are embedded in the economists’ discipline. “The market for apartments in New York, says the economist, is ‘just like’ a curve on a blackboard. No one has so far seen a literal demand curve floating in the sky above Manhattan. It’s a metaphor (McCloskey 1992).”

As McCloskey advocates, we at LMM exploit economic theory’s strength in trying to understand the present. “The trick is not to predict an unknowable future, but to try to understand the present and the probabilities of the various paths that may evolve from it (Bill Miller 1997).” We also recognize that “experts” have varying and often conflicting opinions on the future. One of our favorite demonstrations of this is a monthly report by The Wall Street Journal which asks economic experts to forecast where interest rates will be in six months. Looking at these 50/50 predictions (interest rates will either be up or down in the next 6 months), experts have only been right 38% of the time since 1982. In other words, “experts” cannot even predict a 50/50 proposition.

McCloskey’s little classic is a book that should be read by every serious investor.

The views expressed are subject to change at any time. LMM disclaims any responsibility to update such views. The presentation should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee the views expressed will turn out to be correct.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.