Alex Douglas says that economics “makes very few successful predictions”: that “nothing from economics has improved economic policy in the way that the integrated circuit has improved computing”: and accuses economists of making “logical mistakes.”
I don’t intend to reject his claims, but I’ll give a counter-example from my day job. Back in the early 00s, I read Narasimhan Jegadeesh’s and Sheridan Titman’s paper which claimed that stocks which had risen in previous months tended to continue to rise. I interpreted this as a prediction – that momentum stocks would tend to out-perform in the UK. So I tested it. At the end of each calendar quarter, I took an equal-weighted basket of the best-performing shares* from the FTSE 350 to see how they would perform in the following quarter. And they have hugely out-performed. Since I began the exercise in 2004, UK momentum stocks have tripled in price, whilst the 350 has risen only just over 50 per cent.
Jegadeesh and Titman therefore made a successful prediction – and a useful one too. In fact, researchers have uncovered momentum effects pretty much everywhere they have looked: in commodities, currencies, international stock markets and sports betting.
This is not the only useful and successful prediction in financial economics. The efficient market hypothesis might be much derided (and the great performance of momentum stocks is exhibit A against it**) but it has made a prediction – that investors shouldn’t expect active managers to beat the market after fees – which has been successful.
Or to take another example, back in 1985 Hersh Shefrin and Meir Statman claimed (pdf) that investors lost money because they were too quick to sell winning stocks and too slow to sell losers. Subsequent research by Brad Barber and Terrance Odean has found that this prediction has also been right.
These, I would contend, are only a few of the ways in which financial economics has provided us with good practical advice – successful predictions, if you like.
All this raises the question. How come these predictions have been successful and useful when Alex claims otherwise?
One big reason is that (aside from the EMH) these predictions haven’t been derived in the way that Alex characterises economics – as logical deductions from theoretical principles. Instead, they were gleaned from a careful search for facts. Were Jegadeesh and Titman doing data-mining? I don’t give a damn: they discovered a useful and replicable result.
In fact, this is how economics in general has progressed in recent years: it has become increasingly empirical.
This is not to say that Alex is attacking a straw man. There are still some theory-driven, fact-blind economists lingering on. : I fear that some heterodox economists with their ambitious theoretical attacks upon “mainstream economics” fall into this camp as much as some dogmatic neoclassicals.
However, insofar as economics is useful and progressive, it is not because of the development of grand theories but because of humble fact-gathering. In economics, I am a hardline Blairite: what matters is what works.
* Initially I measured the best performers over the previous three months, but latterly over the previous 12. Consistent with Jegadeesh and Titman’s claim, it doesn’t much matter which you take.