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September 6, 2009

Economic Forecasting

I like to read John Mauldin's email newsletters not because I agree with him, his outlook is way too bearish for my liking, but because he usually brings up interesting subjects. In his latest Thoughts from the Frontline Weekly Newsletter John Mauldin wrote:
We need a new and better economic understanding, not some semireligious adherence to dogma laid down by men who were in no way familiar with current world conditions. Keynes, von Mises, Fisher, Schumpeter, Minsky, Hayek, Smith, et al. were giants. They absolutely must be read and understood. But a real science builds on the work of the former generations and does not hold onto theories as if they were scripture.
Here is my letter in reply:

Dear John:

The "real" problem with economic theory is that it is based on the exact and "predicting" model of physics. Convene a dozen astronomers from capitalist USA , communist China, Christian, Jewish, Taoist, Buddhist, Kepler, Newton, Galileo, etc. and they will predict the position of Mars on January 1, 2020 very closely. Do the same with an equal number of economists and you'll never have this kind of agreement. It is not that some economists are smart and others stupid, it's the science itself which is NOT "predictive." Quite simply, economics cannot make reliable predictions and anyone who thinks it can or should be able to with the right inputs, is wrong.

I believe that the Santa Fe institute has the right direction in economics. Economics is a "Complex" science with multiple possible outcomes any one of which may be selected at random. Events in economics are "emergent" (securitizing emerged in the financial markets, the various derivatives like swaps emerged in the securitization market). These emerging events are simply not predictable.

You might want to watch to a video by Stuart Kauffman, one of my favorite Complexity scientists. The thesis I would like you to concentrate on starts at minute 3 of the first part and ends 4 minutes 30 seconds into the third part. The funny thing is that his prediction of Peak Oil contradicts the central tenet of his talk.

Stuart Kauffman Reinventing the Sacred

If you buy into this thesis you'll have to change your framework because you'll realize that predictions are just guesstimates with little real value.

Ever since I accepted the practical implications of Complexity theory I have changed my investing style, I no longer just look for winners and try to avoid losers but I structure my investments, using stocks and options, in such a way as to either have sufficiently large gains to make me happy or sufficiently small loses to be bearable.

If you have the time I would suggest watching another video:

The Waterloo Institute for Complexity and Innovation.
Stuart Kauffman - The Evolution of Economic Wealth and Innovation

and possibly getting this article from the November 2006 Scientific American Magazine

The Evolution of Future Wealth

Technologies evolve much as species do, and that underappreciated fact is the key to growth
By Stuart A. Kauffman


Denny Schlesinger

Thoughts from the Frontline Weekly Newsletter

The Evolution of Future Wealth

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Last updated March 8, 2009.