Beware of Forecasters who are 99.9% Correct

November 1st, 2013
in Op Ed

Rationality vs irrationality-based accounts of the financial crisis

by Dirk Ehnts, Econoblog101

The European Directorate-General for Internal Policies (best pronounced slightly mumbling, with a francophone accent) has a publication from 2009 that gives two accounts of the financial crisis: one is based on rational, one on irrational agents. In Annex VII both accounts are written up, which is interesting with respect to the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013 given to those thinking about the efficient market hypothesis. Here is what they write on page 112:

Financial Crisis

Follow up:

Our fifth factor is speculation driving uninformative volatility in prices. As explained previously, under the standard theory, markets cannot be continuously semi-strong efficient if analysis is costly. There must therefore be processes whereby prices achieve semi-strong efficiency (if they do achieve it). Since agents differ in their analytical skills, an obvious process is for the most skilled agents to do analysis, then to trade on the basis of their informational advantage (e.g. buying if their analysis suggests matters are better than expected, selling if they are worse) until the new information is fully reflected in prices.

That is the efficient market hypothesis. The other account is largely based on the Turner Review from 2009. So, even if some academics argue that the efficient market hypothesis is just academic, here you have a EU document where the efficient market hypothesis explanations is not only used, but it also comes first. The power of ideas is immense, and still too many people believe that we can predict the future. Those that predicted house prices to rise in Spain, the US and Ireland were correct all the time while the boom was going on, but then they were wrong for just one instance. Afterwards, it became a no-brainer to predict falling house prices. Beware of the people with a 99.9% forecast record. You can predict the future. But you won't be right. More or less, the efficient market hypothesis makes the same point, except from the other direction: you know everything, still you cannot predict the future successfully and make money with that (because the others know everything, too). What an odd discussion.

During the Financial Crisis Inquiry Commission fact-finding mission, former Citibank CEO Charles Prince was asked some questions (document). Did he have perfect information (p. 13, lines 9-14)? Let's have a quick look:

Q As CEO, who directly reported to you? I am trying to distinguish between, you know, at the end of the day I assume every one in the company ultimately reports up to the CEO.
A All 350,000 people.

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