Lawrence Klein: The Economic Fortune Teller

Whenever someone finds out you are an economist, the line of questioning that follows changes quite dramatically. “Do you think the stock market is going to pull back in the next couple months?” “Is the student loan bubble going to pop?” “What should I invest in?”

Suddenly you are a soothsayer, oozing predictive power from your ears.

You will be rich if you save more than you spend

Interestingly, economists rarely predict anything correctly, yet the stereotype persists. For this, we can thank the economist Lawrence Klein.

Lawrence Klein won the Nobel Prize in economics in 1980 for “for the creation of econometric models and the application to the analysis of economic fluctuations and economic policies.” If Ragnar Frisch was the father of econometrics, Klein was the boy wonder of econometrics.

His claim to fame came from his accurate, yet unpopular economic prediction that after World War 2, the United States would experience a booming economy. The popular expert opinion was that after the war, the economy would experience a recession. However, by using complex economic models, he showed that an expansion was on the way.

This prediction pushed Klein and econometrics into the spotlight. His work led him to create the first economic forecasting organization at the University of Pennsylvania called, the Wharton Economic Forecasting Associates, or WEFA. Today, WEFA consults and provides economic forecasts to over 1,500 clients around the world. Klein’s models and forecasting techniques are even used by enormous and powerful organizations like the Federal Reserve and the World Bank.

Klein used big time computing power to create some complex forecasting models

There is no doubt that this is really cool stuff. To be sure, Klein’s economic forecasts weren’t just solving for future equations using past data. He and his team were creating equations on steroids by incorporating the effects of new laws, regulations, and hundreds of variables. Their results, coupled with the established economic theory would get them close to predicting the future economy. This type of work brought ridiculous amounts of prestige and further solidified the assumption that economics is indeed a hard science.

But, it’s not. As great a tool these forecasting models are, they are dangerous and often, incorrect.

First off, economics is the study of humans and how they interact. Humans are not inanimate objects and often change how they act, by simply watching the news. Secondly, the “economy” is more than a complex mechanism. It’s a living, breathing, organism with so many moving parts that it is virtually impossible to isolate any one factor that contributes to growth. People and economists alike forget that these models are built as thought experiments, based on simplified assumptions of how the world would work, and creating imaginary economies that can be tweaked and changed with math.

These models expect that people are always “maximizing their utility” or “smoothing out their consumption over their lifetimes.” But, it doesn’t consider that people aren’t making real life decisions based on complex calculations. Not even economists do this!

Even so, prediction continues to be the holy grail in economics. Given no one in the 1980s predicted the invention of the smartphone or that we would be fighting terrorists regularly, we are still compelled to predict five, ten, even twenty years into the future. At best, it’s laughable. Yet, people pay big money for these forecasts.

We saw just how laughable these predictions are on November 8, 2016, when Donald Trump became the 45th president of the United States. Scores of expert forecasters and statisticians looked like jokes when they predicted Hillary Clinton to win by a landslide. Forecasters then foresaw an economic downturn when Trump became president, yet the economy continues to roar. The list of blatantly wrong economic prophecies is infinite.

We obsess over forecasting because we are human and we like to plan for stuff in the future. It’s natural. Another reason is because every now and again, an economist gets it right. If it is important enough, that one accurate prediction essentially cancels out the hundreds if not thousands of incorrect predictions.

To digress, this reminds me of a joke I heard long ago:

A backpacker is traveling through Ireland when it starts to rain. He decides to wait out the storm in a nearby pub. The only other person at the bar is an older man staring at his drink. After a few moments of silence the man turns to the backpacker and says in a thick Irish accent:

“You see this bar? I built this bar with my own bare hands. I cut down every tree and made the lumber myself. I toiled away through the wind and cold, but do they call me McGreggor the bar builder? No.”

He continued “Do you see that stone wall out there? I built that wall with my own bare hands. I found every stone and placed them just right through the rain and the mud, but do they call me McGreggor the wall builder? No.”

“Do ya see that pier out there on the lake? I built that pier with my own bare hands, driving each piling deep into ground so that it would last a lifetime. Do they call me McGreggor the pier builder? No.”

“But ya fuck one goat…”

The goat at the sight of McGreggor the “Goat Fugger”

This joke is a reminder that people usually hold on to that one bad call, or wrong thing you said that one time, despite being right most of the time. However, when it comes to forecasting, it’s the opposite. You can be wrong hundreds of times, but if you get that one prediction right, you are deemed a forecasting all-star, like Klein.

Klein’s contribution to economics isn’t all bad. In fact, the way he was able to model out how countries interact with each other with these crazy econometric models is nothing short of amazing. Though an incredible feat, Klein inadvertently turned economics into a science of prediction and increased non-economists’ expectations of economists. Now, economists are of the same breed as fortune tellers, and that is a little scary.

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