Key Messages
How Thinking Like A Meteorologist Can Lead To Better Predictions In Economics
The economic landscape is changing drastically, and it’s leaving many economists confused about how to understand and predict it.
In Forecast, Mark Buchanan looks at the flaws in current economic models and outlines a new way of thinking about economics that takes insights from other fields like biology, physics, psychology, or meteorology.
He examines how basic assumptions made by economists can almost invalidate contemporary economic models, discussing the limitations of traditional look at finance – such as the concept of “the invisible hand” for economic cycles.
He also looks into factors such as High Frequency Trading and Leveraging that can improve efficiency but can increase instability.
By combining his knowledge of these vast research fields with economics trends since the 2008 financial crisis, he lays out a model for economics that is more similar to meteorology.
It may be key to predicting future events more accurately and provide us with insight into why the economic landscape is changing so drastically today.
Adam Smith’S Impact On The Development Of Economics – From Division Of Labour To Equilibrium Theory
The concept of equilibrium has been an integral part of economics since its inception.
It was first used by economists to give scientific credibility to early economic discoveries, such as Adam Smith’s theory of the division of labor and his notion of the invisible hand.
Archimedes’ physics and Isaac Newton’s gravitational theories were used to explain how the pursuit of self-interests could eventually lead to beneficial outcomes for society.
Léon Walras then took this concept a step further in 1874 by applying mathematics to prove that supply and demand would eventually reach equilibrium.
By demonstrating how both sides could be satisfied, it went a long way in explaining Smith’s theory.
Today, although many aspects of modern economics have changed since its inception, the concept of equilibrium still plays an important role in our understanding.
By providing the theoretical foundation for Smith’s idea, this concept helps us to understand why pursuing one’s own interests may bring about greater benefit for everyone.
The Efficiency Of Markets: Achieving Optimal Outcomes Through Supply And Demand, And The Rational Use Of Information
It is accepted within the economic world that markets in equilibrium are efficient.
That is to say, when supply meets demand and prices remain at an optimal point for both buyers and sellers, a market can be considered to be in equilibrium – and this is where optimum efficiency lies.
For any saleable good there exists a price point which will satisfy both parties.
Consider a supermarket selling apples at a price of $1 each; if 80 people are willing to pay this amount then all 100 apples would be sold.
On the other hand, were the price lowered to 90 cents all of them would still sell.
This example clearly demonstrates how a market can reach equilibrium between supply and demand.
What’s more, economists have been able to show that these economically-optimal outcomes are also pareto-optimal; meaning no individual can become better off without making someone else worse off.
Returning again to our apple analogy: reducing prices may lower the supermarket’s profits but increasing them may make fruit unaffordable for some households – thus demonstrating why markets should aim for equilibrium rather than financial gain alone.
For financial markets too, market efficiency refers to the way new information is used in order to adjust prices accordingly.
Eugene Fama’s 1970 Efficient Markets Hypothesis (EMH) has shown that stock values fluctuate randomly as investors attempt to capitalize on new information as soon as it arrives – so ensuring that prices accurately reflect reality by reacting promptly to changes in conditions or occurrences within specific companies or industries overall.
Thus we can see why markets are deemed efficient; not only do they use resources optimally but they strive towards providing the best results possible for society as a whole without taking advantage of anyone involved in their exchanges or dealings.
The Study Reveals The Limitations Of The Efficient Market Hypothesis: Human Behavior Plays A Key Role In Stabilizing Financial Prices
Contrary to the claims of the efficient market hypothesis, price changes in the financial markets are not always caused solely by information.
This was demonstrated in a 2009 study in which economists examined how information affected the price level of over 900 stocks over a period of two years.
What they found was that volatility, or fluctuation in prices, stabilized more quickly when it followed news announcements than when it happened after no news at all.
In other words, when people had no explanation for the change in price, they panicked and sold off their investments.
However, when there was a clear reason – like a company announcing liquidity problems – investors had all the information they needed to remain calm and allow prices to stabilize more quickly.
This study shows that basic human nature plays an important role in the stability of stock prices as well as information about markets and companies.
Ultimately, people do not always use information optimally and this can have a significant effect on financial markets.
The Efficient Market Hypothesis Is Based On A False Assumption Of Human Rationality: We Cannot Fully Comprehend The Optimal Amount Of Time To Spend On Research
It is clear that even if we’re capable of being rational, we certainly don’t always choose to act rationally.
This can be seen from Richard Thaler’s Financial Times ad game, in which he asked participants to guess a number between 0 and 100 to win.
Theoretically, the answer should have been 0 – as this would be two-thirds of the average number chosen by everyone else.
However, what was the actual outcome? The average number chosen was 18.9, with the winning entry being 13!
This shows that strong evidence that people rarely behave rationally all the time – and even if they try to do so, it might not necessarily happen.
For example, if you must make an investment decision but are trying to spend the optimal amount of time on research beforehand, it becomes impossible to decide how much time is “optimal” without taking more time out for thinking about it – creating yet another paradox.
In conclusion, while people might have the capabilities of acting rationally at certain points in time, it doesn’t necessarily mean that individuals will practice rationality constantly or consistently.
In fact, it’s questionable whether absolute rationality can exist at all in our daily lives.
Economists Use Virtual Simulations To Understand Market Instability And Leveraging
Research demonstrates that it is possible for a financial market to be both highly efficient and highly unstable.
This is due to the leveraging of hedge funds, which enables them to borrow large amounts of money in order to increase their returns.
Leveraging can help the stock prices stay close to their realistic value and make the stock market more efficient.
However, this comes at a cost as leveraging also makes markets less stable and can lead to severe events becoming more frequent.
If a stock price drops, it reduces the money that a fund possesses and forces it to sell some of its stocks, driving down their value and triggering a selling race throughout the market, leading to great losses.
Hence, this research shows although leveling increases the efficiency of markets, it also makes them more unstable at the same time – something that we must always be aware of when dealing with investments and economic situations.
The Dangers Of High Frequency Trading And How We Could Improve The Economic System
High Frequency Trading (HFT) is an integral part of contemporary stock trading, with technology playing a major role.
Through the use of powerful algorithms that analyze market data and decide when to buy and sell mispriced stocks, traders are now able to turn huge profits by trading massive volumes of those stocks – and they’re doing it all at a much cheaper cost.
However, this cheaper cost means that the stability of financial markets has been compromised.
In 2010, even though only two percent of active traders were engaged in HFT, it still accounted for 73 percent of all traded volume.
The increased efficiency of these algorithms creates an increased demand for stock trading, which drives down market prices – but also increases instability.
This was seen in May 2010 during what is known as a ‘flash crash’, where US stock markets experienced a 9 percent drop within 10 minutes caused by HFT algorithms selling off too many stocks resulting in a chain reaction that caused further losses for investors.
In conclusion, technological advances have made trading cheaper – but they also decrease the stability of financial markets by creating additional risk in the form of flash crashes due to sudden large-scale trades resulting from automated emergency systems kicking in to sell off stocks below certain thresholds.
Earthquakes And Economic Crises Occur Less Often Than Moderate Ones And Share Amazing Similarities, Suggesting Economists Could Borrow Research From Earthquake Studies
Earthquakes and market crises may seem to be two totally different phenomena, but they actually share some surprising similarities.
For one thing, just like earthquakes, major economic crises are extremely difficult to predict – even though we know the basic mechanisms behind such events.
Another similarity is that these extreme events occur less frequently than moderate ones.
Throughout history you can find major economic crashes happening with regularity, but far less often than minor ones.
The same goes for earthquake activity – strong quakes happen less often than weak ones.
Furthermore, their aftershocks are alike as well.
Following an extraordinary market event, or a large earthquake, there is a higher chance of significant movements at first and the probability gradually decreases as time passes by – in both cases.
These substantial resemblances mean that economists could learn a lot from research done in the field of earthquakes and apply it to their own subject matter.
Realistic Economics: Arthur’S Puzzle Shows The World Is Always In Flux
Traditional economic thinking fails to account for the way people actually live.
It incorrectly assumes that people are rational and make decisions in a calculated and intelligent way, when this often isn’t the case.
As seen in Brian Arthur’s bar experiment, rather than making rational decisions based on facts and figures, people tend to rely on theories and strategies that come from their intuition, experience or gut feeling.
The example provided by Arthur showed that students would come up with theories like “If it was crowded last week then a lot of students won’t go this week” or “If it was crowded two weeks in a row then it’s likely to be crowded again this week”.
Through running a virtual simulation of students using these strategies to decide whether to go out or not, he found that the weekly attendance regularly fluctuated around 60%, but never reached equilibrium.
This shows us that traditional economics fails when we take into account human behaviour, as it cannot predict how people will react in any given situation with so much uncertainty.
Therefore, traditional economic thinking is misguided as it fails to consider how people use irrational theories when making decisions.
Understanding this allows us to create more realistic models of the economic world in which prices never reach a true state of equilibrium but instead fluctuate unpredictably around certain numbers – creating a possibly volatile situation where rallies and crashes can occur.
The Fascinating Effects Of Social Influence On Our Perception And Behavior
Social influence has a significant effect on our decisions and behavior, making it a vital element to consider in economic models.
This was proven in 1951 through an experiment by US psychologist Solomon Asch, where people were asked to pick the correct length of a line in the face of other people giving wrong answers.
Amazingly, many surrendered to the pressure and went along with the majority opinion.
In another study conducted recently, researchers found that when asked a question with many participants providing incorrect responses, people’s perception altered accordingly and shifted away from true facts.
This suggests that social influence does more than just influencing our behavior-it actually changes how we see things.
Thus social influence needs to be accounted for when creating economic simulations.
Scientists are now running experiments involving leveraging that make the market more efficient but also less stable.
Utilizing social pressure in these experiments may provide deeper understanding into how to properly manage economies in both direct and indirect ways—and this is why social impact should be factored into economic models: so we can get an even clearer insights into human dynamics.
Can Supercomputers Help Us Forecast The Economy?
If we’re able to predict the weather, could it be possible to do the same for the economy? It’s not just a far-fetched thought anymore.
Thanks to modern computers and simulation algorithms, it’s becoming increasingly possible to forecast economic events.
At the heart of this technology are supercomputers that analyze a simulated atmosphere.
Different meteorological aspects like air pressure and other physical conditions of the world around us can be simulated and tested in order to forecast weather at more than 20 million points on Earth.
What if a similar approach could be applied to analyzing and forecasting the economy? Researchers could use the vast processing power of machines today, with their algorithms simulating different scenarios taking into account factors like leveraging, risk, density of interconnection and social influence.
Mass data collection will play an important role here too – thanks to everyday devices tracking our location, browsing habits and communications with special patches recording our hormone levels.
With such data collection techniques we’d be able to analyze things like human behavior in unprecedented detail – giving us new insights into what drives the greater economic advancements of humanity
Wrap Up
The Forecast Book provides a clear conclusion on the current state of modern economics.
It emphasizes that economics needs to look beyond its own field for answers and should take discoveries from other scientific fields such as physics and psychology into account in order to advance economic theory.
To summarize, the book provides a clear message: modern economics has fundamental flaws due to its reliance on unrealistic assumptions.
Researchers should look towards other scientific fields for solutions, as they may greatly contribute to a more complete understanding of our economy.
Those looking for actionable advice can take away the lesson that knowledge beyond the field of economics is essential in correctly predicting how our economy will behave.
