Uncommon Sense - Pape Scott

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it's impossible to imagine.

      And of course on the other side of the ledger are those living today who otherwise wouldn't be. I'm the son of an Australian Lancaster pilot who met his English bride in London during World War II. It has crossed my mind that if Hitler had copped a bullet in 1915 then I wouldn't be here today, and nor would millions of others.

      One small event would have had a profound effect on the population of the world, not just today but to the end of human history.

      One simple, unpredictable event – a chance bullet. Yet there are those who suggest the future can be predicted.

      A few years ago I was told the true story of a young Australian woman who was fleeing an encroaching forest fire. Having left her threatened home, she was faced with a fateful decision when driving through a nearby town. Should she turn left or right at the end of the main street? She turned left, while the three cars immediately in front of her turned right. She escaped the fire, while the next day the three cars in front of her were featured on the front page of newspapers around the country. The image of those three burnt-out car shells left no doubt as to the fate of their unfortunate occupants.

      Finally (although the examples could be practically endless) consider how the rock band The Rolling Stones came together. More than 50 years after their formation, British officials arranged to honour the spot where Mick Jagger and Keith Richards first met in 1961. Their lifelong association started with a chance meeting on a platform at Dartford railway station.

      Life is a constant unfolding of chance events over which we possess a degree of control, but it's far from absolute. Yet this is not the way most people see things. Typically they view events through a rear-view mirror. Looking back, they see life as a series of events and imagine that was the only way it could have been. It's this flawed perception of how events unfold that delivers the false sense of predictability about the future. But future certainty is a delusion, and those who deliver a message of certainty should never be allowed onto the public stage.

      Economic and stock market predictions are typically delivered as a single narrative. And they sound pretty convincing. Sometimes I'm asked by worried or excited friends, relatives or associates to comment on these predictions, particularly when they're extremely optimistic or pessimistic, as they so often are. My typical answer is: ‘Yep, that could happen. Doesn't mean it will. Probably it won't.'

      Let me use an analogy. Imagine you are on the top branch of a massive tree. To see how you got there, run your eye back down your line of ascent all the way to ground level. Your eye will follow one pathway, from the tip of the branch you're on down to the base of the trunk. Now stand on the ground looking up into the tree. Imagine all the branches you could end up on. Making a prediction is more like being on the ground looking up than it is being on the top branch looking down. There isn't one single course of events leading to one particular outcome. There are many ways things could turn out, and you don't know which will materialise.

      This is the real environment within which you make investment decisions.

      Chapter summary

      • If an ‘expert' is on TV delivering predictions on the future direction of the economy or the stock market, then use the time productively: go and make yourself a cup of tea.

      3

      WHY ECONOMICS WILL NEVER BE A SCIENCE

      My education and much of my working life have been split between science and finance. It's been interesting, as each requires a different way of thinking. The science came first, which meant that when I initially came to finance I mistakenly assumed it would conform to the laws of scientific logic. It doesn't, and I'm certainly not alone in recognising this. This is the opening sentence of Samuel Armstrong Nelson's 1902 book The ABC of Stock Speculation:

      The question whether there is such a thing as scientific speculation is often asked. Various answers of a somewhat affirmative character have been given but they have generally been hedged about with so many qualifications as to be nearly useless for practical purposes.10

      ‘HYPOTHESIS NON FINGO'

      It's time to address the whole science/economics/logic question. So let's begin by describing the scientific process. It starts with an observation. There's usually something about the world that captures a scientist's imagination, so he or she starts asking questions. What's the cure for a particular disease? Why do the planets appear in the sky with precise regularity? Why do objects fall to the ground when they're released? Next they propose a possible explanation for their observations – a hypothesis. And finally they set out to test their hypothesis experimentally.

      The gold standard for experimental study is the controlled study. Two systems are set up that differ in only one respect – the variable being tested for. Both systems are put into effect so the scientist can observe and measure the outcomes resulting from differences in just that single variable. Data is then collected from a series of experiments and tested for statistical significance to establish whether there's a high probability of a cause-and-effect relationship. If other researchers produce similar results when they repeat the experiment, the hypothesis is considered likely to provide an explanation for the observed outcome.

      You can't perform these types of experiments in economics. A simple example will help explain why.

      Let's say you're testing for the pull of gravity on objects of different mass. To do this you release a feather and a lead ball from the same height at the same time. Which one hits the ground first? Answer: it depends. If you perform the test in your living room, there's no doubt the feather will hit the ground long after the lead ball has punched a hole in your shagpile. But that's because there are two forces here. As the Italian physicist Galileo demonstrated four centuries ago, you aren't testing for gravity alone. There's also the opposing force of air resistance, and air resistance slows down the feather much more than it does the lead ball. It hasn't been a fair contest.

      Now perform the experiment in a vacuum, where the effect of air resistance is eliminated. This time the feather and the lead ball hit the ground at the same time. You are now testing for just one variable – their mass. And you have been able to determine the relationship between mass and acceleration under gravitational force. Apollo 15 commander David Scott performed this test in 1971 on the surface of the moon. He dropped a feather and a hammer, and, due to the lack of aerodynamic drag, they hit the lunar surface at the same time. But what if you hadn't been able to test in a vacuum or on the surface of the moon? The effect of gravity on objects of different mass wouldn't have been clear at all.

      That's the problem in testing economic relationships. There are too many variables in the real economy – not just one or two but a near infinite number. And you have no way of isolating them in order to test the impact of changes in each. Simply put, you'll never be able to set up an economic laboratory to test for changes in trade flows, fiscal stimulus, population or any other economic variable you wish to study.

      Which all means economics never gets much past the storytelling stage. The problem is that a story, repeated often enough, starts to sound like a fact. Economist Milton Friedman warned us of how many different stories can be fabricated to explain any set of circumstances when he said: ‘If there is one hypothesis that is consistent with the available evidence there is an infinite number that are.'

      This must have been on Sir Isaac Newton's mind when he was describing the law of universal gravitation. Newton outlined his gravitational formula in Philosophiae Naturalis Principia Mathematica (‘the Principia'), first published in 1687. And in the second edition, published 26 years later, he added the declaration ‘hypothesis non fingo', which translates as ‘I feign no hypothesis'. Newton had observed gravity and proposed an equation enabling the prediction of how objects would move under its influence, but he had no explanation of what actually caused it. He chose not to guess what might be behind it all for risk of being proven wrong later on. He didn't want to risk having proverbial egg left on his professorial face.

      What about the branch of economic study called econometrics? It applies statistics to economic data. That's a bit like trying to accurately measure the physical dimensions of smoke. Which reminds me of that old economic adage: there are two things you don't

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