Citizens vs economists

Ha-Joon Chang says:

Economics is not a science...Very often, the judgments by ordinary citizens may be better than those by professional economists.

He doesn't provide any empiricial evidence for this - that would be too scientific. But I suspect it is true in one sense, and false in others.

It's true in that citizens' - or at least consumers - judgements can do a better job of economic forecasting than the experts. My chart shows how the ratios of consumer spending to house and share prices have done a decent job of forecasting stock market returns over the last 30 years*; this is a simplified version of the famous Lettau-Ludvigson result (pdf), as corroborated by some Bank research. 

The idea behind this is a wisdom of crowds one. If individuals anticipate better times, they are likely to spend more and so consumer spending will be high relative to wealth. If they anticipate bad times, spending will be low. Whilst any individual might be mistaken, their errors cancel out, with the result that aggregate spending forecasts share prices and economic growth. This is a Hayekian finding: there's wisdom in the  dispersed, fragmentary knowledge of millions of people.

1-0 to Chang.

But in other respects, he's wrong. Brad Barber and Terrance Odean have shown that, around the world, most individual equity investors under-perform the market.This tells us that ordinary citizens know less than the experts - because expert advice is to invest in trackers. The efficient market hypothesis of economists might not be perfect, but most individuals would do better if they heeded it.

This poses the question. If ordinary people do worse than experts when they are investing their own hard cash, won't they be even stupider when they don't have skin in the game. Three facts make me think so:

 - George Osborne has a high approval rating, even though orthodox economics, as Simon is sick of telling us, tells us that his actions delayed the recovery**.

 - Many people want benefit cuts, in ignorance of how mean they really are.

 - Most people think immigration has been bad for the economy - in contradiction of most of the scientific evidence.

In these respects, I prefer professional economists' judgments to those of citizens. And I suspect Mr Chang and his readers would too.

This is not (just) a conservative, orthodox opinion. One famous heterodox economist cautioned against relying upon people's opinions of appearances and demanded a scientific approach which looked behind them. "All science would be superfluous if the outward appearance and the essence of things directly coincided" he said.

In truth, I'm not sure Mr Chang believes what he's saying. When Cambridge's economics exams are marked, I suspect it will be by professional expert economists and not by ordinary citizens. But then, radicalism usually stops when it challenges one's own ego and power.  

* The equation here is: 2.12 x consumption/All-share index ratio) + (3.07 x consumption/house price ratio) - 212. House prices are from the Nationwide, consumption from the ONS.

**There's always a danger of falling into "no true Scotsman"-type thinking in defining orthodox economics, but I reckon that if something's taught to first-year Oxford students, then it's orthodox.

Comments

[Shinsei1967]

"- George Osborne has a high approval rating, even though orthodox economics, as Simon is sick of telling us, tells us that his actions delayed the recovery**."

Only because Simon refuses to engage with the counterfactual that monetary policy could not be so stimulative without fiscal austerity (or at least the rhetoric of fiscal austerity).

The world is full of orthodox economists who in the face of unsustainable deficits (and fears over a weaker currency & higher imported inflation) support fiscal contradiction in order to have a more stimulative monetary policy, it's just that not many are to be found in Oxford senior common rooms.

[Thornton Hall]

What kind of twisted psychopath thinks the academy should be populated with good stock pickers? The deeper I get into the econoblogosphere, the more convinced I am that nobody in the field has a coherent idea of "doing economics". Let alone a coherent idea of how it might be socially useful.

[Socialism In One Bedroom]

I note that in the quote Chang says "may be better", so he can't be wrong I guess.

On being an expert in economics, I note that some government ministers struggle to say what the price of a loaf of bread is. In that respect my gran is better at economics than some experts.

[Luke]

How about economists should stop aspiring (if they do) to the status of physics, and settle for engineering? There are some rules, but also a lot of approximations and rules of thumb to deal with messy problems with lots of variables. And it's useful in both disciplines to have an idea of how certain you are.

[An Alien Visitor (back for a second look)]

"with messy problems with lots of variables"

because they don't exist in Physics!

[Dave Timoney]

Chang is advocating public engagement in economic policy, which is a good thing; not least because (as you note in the wisdom of crowds/self-fulfilling prophecy story) macroeconomics is simply aggregate behaviour.

The less we think of it as a remote force of nature (that is best abstracted via science), the more we consider our own responsibility. This is therefore an ethical stance, and thus something we should applaud.

Re your contra-Chang examples, individual equity investors underperform trackers in the same way that gamblers (on average) do worse that random number generators. The assumption has to be that they piss their money away for other reasons, such as endorphins or a love of stubby pencils.

[TD]

"most individual equity investors under-perform the market... this tells us that ordinary citizens know less than the experts - because expert advice is to invest in trackers."

Equating "individual equity investors" with "ordinary citizens" seems problematic, since surely there are ordinary citizens who DO invest in trackers? How do you know that the ratio of ordinary citizens investing in trackers is lower than the same ratio of experts?

[Christiaan Hofman]

All you've really said is that individuals are crap predictors, and crowds are good predictors. That's not really surprising, and I don't really think it says anything about consumers versus economists.

[Andrew]

Interesting Lettau-Ludvigson paper - thanks.

I'm uneasy about the suggested mechanism of the predictive power of consumption/wealth over stock returns.

Surely increased consumption relative to wealth is itself a driver of stock returns over the forecast period. And surely a low wealth relative to consumption is something that might return to the mean (via increased stock returns)?

Is this really prediction rather than causation? I don't think Lettau-Ludvigson address this hypothesis.