Predicting the future of the economy

In the last week, the Economist and the Financial Times have both told us that macroeconomics is in a state of meltdown because it failed to prevent or predict the global financial crisis. This is more than a spat in the corridors of academe. In the real world, it actually makes it harder to predict the future of the current financial crisis, and potentially increases volatility.

The problem is that we always rely on some kind of interpretative theory to anticipate the future. If everyone agrees on the appropriate macroeconomic prescription then the future outcome looks predictable. But if the macroeconomists advising governments are divided into two warring factions, who should investors – on whom a recovery partly depends – believe?

If they go with the Ricardians, as Paul De Grauwe points out in Wednesday's FT, they will believe that vast government fiscal stimulus will doom the economy to hyperinflation. If they side with the Keynesians they will think it is the very thing to spark a return to economic growth. In the first case investors will sell long-term bonds, causing bond prices to drop, interest rates to rise, and – if there are enough of them – making their worst fears come true. In the second case, investors will buy bonds, letting governments spend without driving up interest rates, and so will contribute to making their own sunnier view come true. And if investors vacillate between the two views, the result will be more volatility.

But surely, you may say, one of these views must actually be the true one? Welcome to the world of complex adaptive systems and reflexive behavior. Which one turns out to be true may simply be the one more people believe in and act on. In that case, we had all better become Keynesians.