The letter concluded: "In summary, Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off ... was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole."
The damage to economists' reputation from the Queen's question was not confined to the LSE. The Financial Times, (FT) writing up the LSE events, acknowledged that "It has been a bad year for economic forecasters". Reviewing various comments from the Federal Reserve, Bank of England, IMF and other august economic organisations showed all of them were far more positive than subsequent events justified.
Among independent economists, the FT noted "the record has been just as bad".
And in a rare journalistic mea culpa, the article went on to admit "the media cannot claim better foresight". The FT writer even acknowledged his personal embarrassment, when he re-read his own assessment from three months before the GFC, that recession "might happen, but Britain is not there yet, and not even close".
One of the few claims the FT could find of accurate economic prediction leading up to 2008 came from Italy's then Finance Minister, who suggested the Pope had been the first to foresee the GFC. Even if correct, that did nothing to salvage the reputation of economists.
What can we learn from these inaccurate predictions of 14 years ago? Why did brilliantly skilled and informed economists get things so wrong in 2006-08, one of the last times major economic difficulties faced the world?
And more importantly, will economists make a better job of accurately predicting any downturn which may be ahead of us in 2022? It is a question which currently assumes very real importance, as numerous danger signs appear in world economies.
First, it has to be acknowledged that predicting the future in any sphere is a hazardous task. Ask pollsters who seek to predict the outcomes of elections.
Economists face similar challenges. Yes, they build mathematical models of their economies, which in theory should tell us what inflation, unemployment and other economic variables will be next year.
But the behaviour of economies ultimately reflects the behaviour of the citizens who make up those economies. Unfortunately, humans do not always behave logically and consistently. That means that attempts to reflect their behaviour in mathematical models is always going to be an approximation at best.
Then today we have major economic interventions by central banks and governments. The economy will perform differently, depending on the policies these key actors put into place. So in addition to analysing economic fundamentals, economic predictions need to factor likely policy changes into the mix.
The only real question in economic forecasts is not whether they will be right or wrong, but how wrong they will be. Accurately predicting the future of economies is never possible.
In some ways it is unfortunate that economists habitually give numerical predictions for economic variables, when merely indicating the direction of that variable (that inflation will grow or decline, for example) is probably all that should be attempted.
But there is one further special aspect of forecasting which is peculiar to economics. The forecast itself can influence the way the economy performs. Say the IMF reported that the New Zealand economy was in difficulty. Humans are herd animals. Markets reflect that herd behaviour. Get investors believing that things are headed down, and the negative prediction becomes self-fulfilling. Investors rush out and sell, and markets decline.
This matters less if a predicted upturn drives markets higher. It can, however, be most unfortunate if a negative economic prediction sends markets significantly lower.
Therein lies the conundrum of predicting an impending economic downturn. Negative economic predictions may end up being self-fulfilling — an outcome economists are clearly anxious to avoid. Talk markets up perhaps; but try not to talk markets down.
Perhaps the answer to the Queen's question, was that yes, economists failed adequately to see an economic downturn coming in 2008. But also, having imperfectly seen the economic storm approaching, it was not easy for them to point out the impending danger sufficiently graphically, without themselves adding to that danger.
These same considerations have not changed, and remain equally important limitations on economic forecasting in 2022. Meaning it would be unwise for investors to assume that because there is still talk of soft landings, and not all economists are currently ringing alarm bells, that world economies in 2022 are safe from significant danger.
- David Schnauer is an economist, retired lawyer and the author of Covid, Catalyst for Change.
