Dorset Economy blog 52: Quantum Forecasting & Economics

BU's emeritus Professor Nigel Jump writes the next in his series of blogs on the Dorset economy. 

Many cosmologists now believe that quantum mechanics determines the shape of, and changes in, our Universe.  In simplistic terms, the Universe is made of a myriad of particles and waves.  A priori, their interactions are hard to assess, making it difficult to predict potential outcomes or specify probable histories as the cosmos evolves.  Future outcomes are largely unforecastable at a micro scale of matter, energy and the forces … even though, at a macro scale, we see familiar patterns of stars, planets and galaxies, and we derive some ‘laws’ of physics as to how they interact and evolve.

I am struck how Economics is similar.  There are billions of consumers, millions of companies, and zillions of money quanta and markets.  Each ‘actor’ is like a quantum particle – e.g. we know either the amount of money or its velocity but not both.  We know which economic variables are related to others and how their relationships seem to have worked in the past.  We can estimate and forecast trends with sophisticated models, but seldom can we determine the exact scale or the timing of future events.  We can judge economic matter and energy in broad (macro) terms, but we cannot predict the detailed (micro) evolution of the economic world. 

The equivalent to dark matter and energy that keeps the Universe expanding is reflected in the fundamental economics equation of...

MV=PT - the quantity theory of money

...where M is the stock of money, V is its speed of circulation (how it turns over), P is the aggregate prices of goods and services, and T is the level of total transactions.

For example, experience teaches us that higher interest rates tend to lower price inflation and growth.  But, we cannot ‘know’ the scale or the timing of these relationships in any specific economic cycle, because how the interest rate mechanism impacts each of the fundamentals is volatile.  There are too many financial and non-financial ‘particles’ and ‘waves’ to predict point results even though we often know the right sequences.  So, higher interest rates resulting from excess monetary growth (M) tend to impact activity (T) before the inflation target (P).  Curing inflation requires a period of slow/negative growth.  Changes in velocity (V) are uncertain as to strength and timing because behavioural responses of all the different quanta are always uncertain.

Therefore, nearly all forecasts are wrong and, usually, when they are right it is mere coincidence.  Relatively, the weather forecasters have cracked it with atmospheric modelling of real time data.  Moreover, to paraphrase the famous economist, J K Galbraith: “economic forecasting makes astrology predictions look good”.

Nevertheless, sound or understandable economic forecasts can be useful because they offer a basis for argument, policy setting and decision making by the full range of economic actors.  Simplistically, if I am a firm, a family or a government, I will make better planning and policy decisions, strategically and tactically, if my ideas/decisions are based on some sound economic framework.   And, just like the astronomers, I can learn a lot for next time from understanding my errors this time in the endless search for truth and meaning.

Moreover, if behaviour shifts because of a change in forecasts of supply, demand and prices, economic outcomes can become self-fulfilling.  If my model makes me think there will be a recession or a boom and I change my behaviour accordingly, I help to make the recession or boom happen even if I still cannot judge exactly when or what form the cyclical changes will take.  In anticipation or acknowledgement of recessions, people often cut back on consumption and investment in a way that reduces demand and supply and slows everything down.  Moreover, shocks can nudge an economy in predictable ways even if it’s hard to judge exactly where, when or how the particular shock will bite.  Brexit, the Covid Pandemic and the current wars in Ukraine and Gaza all show such ‘shock’ effects.

So, what can we see and predict right now in this election year?

1) The current data says (see first Table below):

• Output is flat to worse: a technical recession occurred in second half of 2023.  Importantly, real GDP/head has fallen for 7 consecutive quarters and remains no higher than it was pre-pandemic.
• Aggregate prices are still rising too fast: inflation is volatile and undermining many real economic variables.  Interest rates should remain at 5%+ until inflation settles, giving useful rate of return signals to investors and savers.
• Jobs are available but the market is a little weaker than before:  real incomes are under pressure from the cost of living and vacancies are softening.

RGDP = real gross domestic product CPIH = consumer inflation including housing
PMI = purchasing managers’ index- survey of regional activity. Sources ONS & SPGlobal

This latest ‘photo’ of the economy, taken at one point of time, is useful but needs careful interpretation.   It is where these rates of change have come from, and where they are heading to, that matters.  This is where the quantum forecasting problem lies in economics.

2)  Current point forecasts suggest a consensus (second table below):

• Output growth will remain sluggish – still slower than desirable in 5 year’s time.
• Price inflation will come back to, and then below, target.
• Unemployment will not rise sharply.  Jobs will remain available.
• The economy is judged to be on a flatlining path for the foreseeable future with public debt staying at around 100% of GDP.

OBR November 2023

It will be essential to reflect how much these forecasts change with the March Budget (see next month’s blog).

Meanwhile, the final part of any forward-looking jigsaw is an assessment of any assumptions made and measured risks.  Many forecasters, such as the Bank of England, do this with fan charts of the different forecasts to indicate the probabilities around uncertain outcomes: the central view gets the headlines but the distribution of risk around that is arguably more important.

The upcoming UK Budget 2024 will probably announce a range of (pre-election) items chosen to help the economy move forward.  The OBR will revise its forecasts based on these ‘new’ policies.  Time will tell how accurate these views are.  I suspect not very.  So, we hope for the best and plan for the worst, recognising the consensus coming from current quantum forecasts.  Investment is based on modelling a deeper understanding of product innovation and skills (supply factors) and personal expenditure and tastes (demand factors) within the context of changing entrepreneurial and competitive markets.