Making the Right Decisions in an Uncertain World
It is often said in these times that Economics and more frequently Economists are not able to predict what is happening in the world.
The chaos that is happening all around the world in financial markets appears to confirm this belief.
But in fact there is a great deal we can learn from the study of business and finance.
Firstly, we have to remember that there are broadly speaking two types of prediction made by economists, the self-fulfilling and the self-denying.
While it is quite frequent for people to consider the self-fulfilling predictions such as increasing bankruptcy and foreclosures.
The more people believe this the more fees, interest rate rises and other costs will be imposed on borrowers to guard the lender against the loss.
These higher fees, without doubt, increase the likelihood of the borrower not being able to pay back the loan.
Expectations such as rising house prices, higher stock prices and others all reinforce themselves and become more likely to be true the greater the number of times they are retold.
However, we must also remember that there are self-denying predictions that may easily reduce the economists credibility even when they would otherwise be perfectly accurate.
When predicting the future the weather man has the advantage because the air, sun and sea cannot alter merely because of our beliefs about their future behaviour.
Although some might not believe it, the likelihood of rain is independent of the weatherman's prediction of sunshine.
This cannot be said of those that make predictions about the economy.
There are several areas that making predictions about the economy will automatically make it unlikely that it will happen.
We can see what this means if we consider an example.
If we take the example of future commodity prices, in this case a credible prediction of higher prices will lead to firms in the industry making the decisions based on that predicted future price.
The higher the prices are predicted to go the more incentive there is for firms to increase output to take advantage of these higher market prices.
This response to increase output might well mean that the total quantity in the market is much higher than was anticipated when the prediction was made.
As a result the prices would be suppressed by the larger quantity seeking purchasers in the market place.
This means that by definition it is impossible for the future prediction to be accurate.
The very act of making a prediction alters the outcome.
The important point comes when making a decision in knowing which of the predictions are likely to reinforce themselves and become more true, and which will do the reverse.
Before making any irrevocable decisions it is always important to consider how others will act to the same piece of information.
If output cannot, or likely, will not be increased then predictions of rising inflation will also be self reinforcing.
Conversely, a precise figure will almost certainly be inaccurate as its very value will change what would, or should have happened.
The chaos that is happening all around the world in financial markets appears to confirm this belief.
But in fact there is a great deal we can learn from the study of business and finance.
Firstly, we have to remember that there are broadly speaking two types of prediction made by economists, the self-fulfilling and the self-denying.
While it is quite frequent for people to consider the self-fulfilling predictions such as increasing bankruptcy and foreclosures.
The more people believe this the more fees, interest rate rises and other costs will be imposed on borrowers to guard the lender against the loss.
These higher fees, without doubt, increase the likelihood of the borrower not being able to pay back the loan.
Expectations such as rising house prices, higher stock prices and others all reinforce themselves and become more likely to be true the greater the number of times they are retold.
However, we must also remember that there are self-denying predictions that may easily reduce the economists credibility even when they would otherwise be perfectly accurate.
When predicting the future the weather man has the advantage because the air, sun and sea cannot alter merely because of our beliefs about their future behaviour.
Although some might not believe it, the likelihood of rain is independent of the weatherman's prediction of sunshine.
This cannot be said of those that make predictions about the economy.
There are several areas that making predictions about the economy will automatically make it unlikely that it will happen.
We can see what this means if we consider an example.
If we take the example of future commodity prices, in this case a credible prediction of higher prices will lead to firms in the industry making the decisions based on that predicted future price.
The higher the prices are predicted to go the more incentive there is for firms to increase output to take advantage of these higher market prices.
This response to increase output might well mean that the total quantity in the market is much higher than was anticipated when the prediction was made.
As a result the prices would be suppressed by the larger quantity seeking purchasers in the market place.
This means that by definition it is impossible for the future prediction to be accurate.
The very act of making a prediction alters the outcome.
The important point comes when making a decision in knowing which of the predictions are likely to reinforce themselves and become more true, and which will do the reverse.
Before making any irrevocable decisions it is always important to consider how others will act to the same piece of information.
If output cannot, or likely, will not be increased then predictions of rising inflation will also be self reinforcing.
Conversely, a precise figure will almost certainly be inaccurate as its very value will change what would, or should have happened.
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