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WHAT ARE THE DANGERS OF PREDICTION?

On 15th February 2012, Mervyn King, head of the Bank of England, made a lengthy speech giving economic projections about the economy of the United Kingdom.  Undoubtedly, a great deal of work had gone into preparing and processing the data, the interpretation of which was:  Modest growth might be expected and that the UK would not slip back in to recession, UNLESS the price of oil increased.

Four days later Iran announces that it will no longer sell oil to the UK or France, as a direct response to the pressure being applied to them about the nuclear energy generation.  Their justification could easily be – “if we are not allowed nuclear power then we are going to need out oil for energy”.  Consequently, oil, and the commodity market in general, has risen sharply, rendering all its forecasts meaningless in an instant.

The credit rating agencies use similar financial predictive mechanisms as a service to investors to show how likely it will be that a country will repay their debts.  When a country’s rating is downgraded, the investors demand a higher interest rate because of the greater risk, which in turn makes it more difficult for that country to meet their obligations. This is a known issue called “pro-cyclic” and despite proposals to prevent it from happening, it is impossible to do so.

Physicists and philosophers have long understood the problem concerning interactions between the observer and the observed.  From the Heisenberg uncertainty principle to the “if a tree falls in a forest and no one is around to hear it, does it make a sound?” thought experiment, the issue remains the same.

The instant someone makes an observation about the future, the future changes.

There is something known as a self fulfilling prophecy, this happens when enough people believe in a prediction, they change their behaviour because of their belief.  This change in behaviour then brings about the future that was predicted.

I am certain that this was what Mervyn King was hoping when he delivered his speech – if enough people believe that recovery is happening then they will start to reinvest in the economy, thus causing the recovery he wishes to see.

In the case of the credit agencies it is exactly the same, by predicting that a country or organisation will fail to repay their debts, they create a situation where this event is even more likely to occur than if they had made no prediction at all.

Despite all the mathematic modelling that has been done, there appears to be one very important thing being missed, especially when dealing with people:

“Future success can’t be judged on past performance”

or, as Albert Einstein put it:

“Anyone who has never made a mistake has never tried anything new.”

Most people tend to learn from their mistakes, either that or they just want to prove you wrong.  Either way, predicting the market or financial system is not a good idea, as it can be viewed as no more than a misguided attempt to influence or control those mechanisms.

The power of belief is not a thing to take lightly, and in this current  economic and political climate people need to believe that the world of finance are starting to see a bigger picture than the narrow view of a bottom line.

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2 responses

  1. Füstös Ágnes

    A kimondott szónak teremtő ereje van.
    Isten úgy teremtette a világot,hogy kimondta:Legyen …..
    …. és lett.
    Mindannyian Istenből 1-1 csepp vagyunk. Mi is teremtünk a szavainkkal,gondolatainkka.
    Utána meg nyavajgunk,hogy nem ezt akartuk…

    February 21, 2012 at 4:32 am

  2. Fitch’s new ratings on Greece do nothing to help resolve the situation there, rather it is going to make things worse. We give too much power to these agaencies by allowing them to do anything other than releasing data and letting investors make up their own minds.

    Do they not have a vested interest in being proved right? Or could this be an attempt to manipulate the Euro against the value of the Dollar?

    February 22, 2012 at 1:47 pm

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