Economists make a handy, if mildly irreverent, distinction between “freshwater” and “saltwater” economics. Freshwater refers to economic theory that rests on the efficient markets hypothesis — a belief in the efficiency and rationality of free markets. It is associated with Milton Friedman and the University of Chicago school. It was the thinking behind Thatcher and Reaganomics and still more-or-less holds sway today, or it did up until the credit crunch.
Keynesian or saltwater economics by contrast holds that free markets often behave irrationally and inefficiently, and therefore need corrective policy from government. Saltwater economists say people and institutions often behave in ways contrary to the general good, or in ways that can bring markets (on which they depend) to their knees. Sound familiar?
Anyway, a recent Knowledge@Wharton article comments: “Like a natural science, freshwater economics lends itself to complex, often elegant mathematical modeling. The freshwater view is that consumers, offered an array of choices, will select the one that is best for them — a straightforward assertion that can be neatly expressed in mathematical formulae.
“In contrast, many assertions made in behavioral economics are more challenging to express mathematically. ‘Behavioralists’ argue that consumers don’t always act in their own interests, especially when they fail to understand the choices on offer or succumb to irrational impulses involving those choices… but such impulses are inherently vague and difficult to define.”
Cognitive bias
In other words mathematically modeling the economic future is possible if humans and the markets they create are rational, but far less possible if we act irrationally.
Now, as elaborated in Future Savvy, the fact that humans make irrational choices due to many cognitive biases and heuristics is indisputable, not least since the work of Tversky and Kahneman. Biases and heuristics such as “anchoring,” “recency effect,” “personal validation fallacy,” “herd mentality,” and so on, in which people make irrational choices, are well documented.
That’s why mathematical projections of economic behavior are unreliable. The economy may be counted in numbers, but it is still a human system, with associated inefficiency and irrationality. Blow this little debate in economic forecasting up large, and you have the essential problem with quantitative forecasting of any type. It assumes, erroneously, a freshwater view of humanity.
