Posted by: Dirk | January 6, 2010

Predictions and fundamentals

There is a long-standing feud between economists and investors that can be summarized by a dialogue like this:

Investor to Economist: If you’re so smart, why aren’t you rich?

Economist to Investor: If you’re so rich, why aren’t you smart?

While their is a grain of truth in the answer, I can now think of a better one. What I have in mind is an analogy with biology. Biology and economics share many common ancestors. Growth theory is also known to biologists, who look at growth of plants and animal populations. Mathematical model can be quite similar.

So, if you believe that a know-it-all economists still can’t predict markets even when they know all fundamentals, then surely know-it-all biologists must be able to predict how an animal looks like when they know its fundamentals, a.k.a. genes, right?

Well, actually, wrong: can’t do. Richard Dawkins describes this problem on p. 247-8 of his new book The Greatest Show on Earth:

What goes on inside cells, similarly, is governed by local rules that apply to molecules, especially protein molecules, within the cells and in the cell membranes, interacting with other such molecules. Again, the rules are all local, local, local. Nobody, reading the sequence of letters in the DNA of a fertilized egg, could predict the shape of the animal it is going to grow into. The only way to discover that is to grow the egg, in the natural way, and see what it turns into. No electronic computer could work it out …

Given this statement, it seems ridiculous to demand from economists that they predict how stock markets, exchange rates, growth rate, interest and inflation rates and so on will move. Does this mean then that economists are useless? Of course not. Just as biologists are not useless and can still learn a lot about how the world works economists can do so, too. They might not be able to predict turning points, but they might understand the underlying processes and dynamics. This knowledge could lead to better institutions for development – very helpful for society at large.

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