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Using Foresight In Economic Thought Schools

Prof. Dr. Elif CepniBahcesehir University, Istanbul

The First International Conference on ANTICIPATION  

5-7 November 2015, Trento (Italy)  

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• The main aim of this paper is to show the role of expectations (formulation of future decisions) in main economic thought schools and

• the possible results of replacing the current ways of formulating expectations with foresight or scenario creation or adding the role of scenarios into the theories of main economic thought schools.

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The paper is organized as follows:

•Firstly the importance of the topic will be discussed.

•In the next section the brief summary of the related theoretical literature of the formulation of expectations in economic thought schools is presented.

•This section is followed by the title discussing “why prediction is not possible”.

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•Then the summary of foresight methodologies will be presented.

•Finally the possible results of replacing current assumptions of economic thought schools (on the formulation of expectations) with foresight (scenario planning) will be discussed.

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Combining economic literacy with intellectual foresight may eliminate time inconsistency and credibility problem for policy makers and can also eliminate time lags of policies.

Using collective intelligence may create different roadmaps for countries, societies and institutions.

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Both at macro and micro levels decision-making is very difficult. Almost all decisions are taken under a great risk or uncertainty.

The literature of economics is covering the rational irrationality and the illusion of predictability terms now. The world is full of information. Information is more complex, interdependent, hectic, nonlinear, coevolutive and less stable.

It is known that the occurrence of extreme events cannot be predicted from past history.

• Could it be possible to change our ideas about “what is possible”?

• Is the wisdom of crowd (collective genius) possible? Wisdom of the crowd requires trust, support by the government, enforcement.

• Crowds can be mad as well. To be wise it needs to be diverse in its membership (Goddard and Eccles, 2013).

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• There is one truth; our decisions are heavily affected by our cultural heritage.

• Although there is no common definition of “culture” it may be defined as “the unique combination of expectations, written and unwritten rules, and social norms that dictates the everyday actions and behaviours of people”.

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• Economic life is full with uncertainties.

• Moreover three words characterise the orthodox view of the economy; they are

• efficiency,• stability and • rationality.

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• We live in a turbulent world. Plans, strategies and policies are based on fixed goals. But the environment that we live and the conditions are changing very rapidly.

• Corporate and government responsibilities are changing very rapidly. We the human beings own better social capital and can use collective intelligence in a better way.

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Recently we hear more technical terms in economics such as “The Rational Irrationality” and “The Illusion of Predictability”.

So how collective intelligence can dominate our selfish neurons?

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2. Literature Review of The Formulation of Expectations in The Economic Thought SchoolsEconomist generally categorize economic thought schools under seven titles. These are Orthodox Keynesian, the Orthodox Monetarism, New Classical Macroeconomics (Mark I), New Classical Macroeconomics (Mark II) ( also it is called the real business cycle theory), New Keynesian Economics, Austrian Economics (Von Mises, Von Hayek) and Post Keynesian Economics.

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Within macroeconomics there is a great deal of controversy about the causes of aggregate fluctuations in economic activity.

Classical economists were aware that capitalist market economy could deviate from its equilibrium level of output & employment but they believed that.

Such disturbances would be temporary & short lived. The market mechanism would operate quickly and efficiently to restore full employment equilibrium.(No need for stabilization policies). There is no involuntary unemployment in these models and money is neutral.

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Long run money neutrality is a crucial property of the classical. Contributers were Cantillon, Hume, Ricardo, Mill, Marshall, Fisher, Pigou, Hayek and even Keynes. More recently the Quantity Theory of Money has been associated with the development of monetarism and the work of Milton Friedman. The term "monetarism" emerged in 1968.

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• Keynes sets out to discover "what determines at any time the national income of a given system and the amount of its employment (the national income). He constructs Y (national income) depends on the volume of employment.

• In Keynes's model Investment depends on the expected profitability and interest rate. Keynes called expected profits “The Marginal Efficiency of Capital”.

• In this model employment is dependent on an unstable factor which is investment.

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• Investment decision is difficult. Machinery & buildings are bought now, produce goods that will be sold in a future which is uncertain.

• Expectations about future involves HOPES & FEARS as well as hard facts.

• Given the VOLATILITY of EXPECTATIONS, often driven by “ANIMAL SPIRITS". THE EXPECTED PROFITABILITY of CAPITAL must also be HIGHLY UNSTABLE.

• Investment Decisions could be influenced by tides of "Irrational Optimism and Pessimism" causing large swings in the STATE of CONFIDENCE.

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Expectations of the future profitability of investmentare far more important than the RATE OF INTERESTin linking the future with the present.

The assumption underlying Orthodox monetarist analysis is that; expected inflation adjusts to actual

inflation only gradually in line with the so- called"adaptive" or "error- learning expectations" hypothesis.

In the adaptive expectations hypothesis which is calledbackward looking approach, expectations will be biased.

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• Economic agents base their expectations of future values (such as inflation) only on past values.

• The main reasons of these results (biased) are the assumptions that they use.

• 1. Economic agents only PARTIALLY ADJUST their expectations by a fraction of the last error made

• 2. The failure of agents to take into consideration additional information available to them other than past values of the variable, despite making repeated errors.

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• In contrast, in the "forward looking approach" agents will not form expectations systematically wrong over time, that is, such expectations will be unbiased.

• Schools known as classical started to use “the rational expectations hypothesis” associated with the work of John Muth (1961) in the context of microeconomics.

• It took almost 10 years before Lucas, Sargent and other leading New Classical economists began to incorporate the hypothesis into their macroeconomic models. There are weak & strong versions. In the strong version (the rational expectations hypothesis) it is assumed that expectations of economic variables “ON AVERAGE” will be correct.

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• Rational Expectations does not mean that agents can for see the future exactly. "rational expectations" is not the same as "perfect foresight".

• With rational expectations, agents expectations of economic variables on average will be correct that is will equal their true value.

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• The issue of whether individual agents operating in DECENTRALIZED MARKETS will be able to "learn" the true model of the economy has been the subject of considerable debate.

• 3. Why Perfect Prediction is Not Possible (The Illusion of Predictability, Rational Irrationality)

• Nassim Nicolas Taleb presents the disorder family (or cluster) in his book having the title “Black Swan”. These are listed as follows;

• Uncertainty, Variability, Imperfect and Incomplete knowledge, Chance, Chaos, Volatility, Disorder, Entropy, Time, The Unknown, Randomness, Turmoil, Stressor, Error, Dispersion of outcomes,

Unknowledge.

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• He also mentions about “negative empiricism”. Seeing white swans does not confirm the nonexistence of black swans.

• A thousand days cannot prove us right, but one day can prove us to be wrong. We can get closer to the truth by negative instances, not by verification. It is misleading to build a general rule from observed facts.

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• Most economic models rest on the assumptions that shocks are normally distributed which means that their distribution has the well-known “bell curve” shape, with a given mean and standard error.

• There are, however circumstances in which this assumption cannot hold; shocks may be skewed, in which case their median value is not equal to their mean, or their distribution may exhibit” fat tail” meaning that very rare events are more likely to occur than under normal distribution.

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• There are lots of economists who are arguing that current assumptions of the theories of economics are unrealistic. In many schools they use similar assumptions. These are;

• agents aim to maximize utility and profit,• agents form expectations rationally and do not

suffer information asymmetries, • there is a price flexibility, • there is a continuous market clearing

• so that equilibrium always prevail.

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• Although New Keynesians underline and accept the importance of

• imperfect competition, • incomplete markets, • heterogeneous labour and • asymmetric information • still they use the micro foundations of macro in a

similar way.

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• The economy is

• unfair (income distribution is unequal, • unstable (asset prices are fluctuating very much

like oil and gold) • and unsustainable (over-crowding, climate

change etc) and

• some economist like David Orrell claims that economics needs a scientific revolution.

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4. Literature Review of Foresight and its Methodologies

Scenario planning is generally attributed to Herman Khan and the RAND Corporation in the 1950s.

Kahn developed “future-now” thinking technique and also he used Hollywood’s term “scenario”.

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• He developed his scenarios as a part of military strategy research conducted at RAND for the US Government.

• In the 1970s scenario planning spread outside the RAND. Royal Dutch/ Shell and others started to use.it.

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• In Europe the Copenhagen Institute for Future Studies and the Swedish Secreteriat for Future Studies started to use more qualitative and policy oriented methods (Lindgren and Bandhold, 2009).

• The 1970s were the golden years. Many institutions were added to the list of institutions promoting future studies. Universities started to offer Master’s degrees in the field.

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• While FORECAST is used as a term for predictions, FORESIGHT describes a more open perspective on futuristic thinking.

• FORESIGHTS focus on the identification of possible futures, potential issues, tendencies, and uncertainties, often using scenario methods. Foresight is similar to the term prospective analysis.

• FUTURES STUDY means all types of studies concerned with the exploration and analysis of future states could be named futures studies. Traditionally, the term applies to studies with a 10-30 year horizon.

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• There are lots of technical terms created by consisting foresight in it;

• Private Foresight, • Social Foresight, • Strategic Foresight, • Participatory Foresight and more.

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• 5. Combining Foresight with Main Arguments of Economic Thought Schools

• To predict the future is not only very important for policy makers, but it is very important for all decision makers, decision theorists and economists.

• Since the beginning of time people are trying to predict the future by consulting to stars by observing previous events to understand the possible trend and some scientific methods and simulation models.

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• If we start using foresight in the formulation of economic decisions can we avoid time inconsistency?

• Can we solve credibility problem?• Can we eliminate Lucas Critique?

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• Lets assume government announces a policy which is determined by scenario planning which means using collective intelligence (so the probability of believing is high) than there are two alternatives, either it is believed or not.

• If it is believed by the public and government apply the policies strictly and there occurs a deviation (to understand the deviation economic literacy must be applied) people may understand the role of external and uncontrolled factors.

• This will give us neutrality of economic and social decisions.

• Without losing credibility governments can apply the alternatives (which is more suitable for the new current environment

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• If government cheats and apply totally different policies then in the short run they may obtain some gains but in the long run to gain credibility again will be extremely difficult.

• Governments (institutions or corporates) will think about intertemporal trade-off between the current gains and the future costs.

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• If the announcement is not believed and a government applies it correctly (using foresight and economic and social literacy (due diligence) it could be tested) governments can gain credibility within a short time period (so we need data and measurement).

• If it is not believed and a government applies a different policy (the public is right not to believe in) than these scenarios cannot be applied for a long time horizon.

• We will come back to today’s model.

• Current role of expectations can be replaced by the scenarios created by the collective intelligence.

• But this time another important issue will arise. • Who will determine scenarios? Who will be these

intelligent people. Related with the formulation of successful scenarios we need to develop more methods (EPISTLE).

• Economy and market• Politics• Institutions and organizations• Technology• Legal changes• Ecology and ethics

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• The problem here will be • “whether governments/institutions/ corporates

can accept the loss of power (the decision making power).

• They will have execution power.

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• People may count on collective intelligence more than politicians.

• The probability of believing will be high and even if there appears a deviation from the planned scenarios (by using economic literacy) they may see the role of external factors and will keep believing in the same things.

• So deviations will be short lived. Instead of using adaptive or rational expectations we may use collective expectations.

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• The shift from a mechanistic to a holistic and ecological worldview can be seen as a paradigm shift. The basic tension is one between parts and the whole. The emphasis on the parts has been called mechanistic, reductionist, or atomistic; the emphasis on the whole, holistic, organismic, or ecological.

• To solve the complexities of globalization, to make people happier healthier and wealthier ELIF (Economic Literacy and Intelligence Foresight) method could be a good alternative to current traditional ways of decision-making.

• THANK YOU

• FOR YOUR ATTENDANCE & PATIENCE

• Prof.Dr.ELIF CEPNI

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