Is economics a science or an art? I don't think anyone has yet come up with a clear answer. Economics uses scientific method and, at one extreme, its mathematical models are so complicated that they appear to require brains of Einstein-esque proportions to understand them. Then again, Einstein's theories generally (no pun intended) work. There may still be a few major inconsistencies with the laws of quantum mechanics, but the Theory of Relativity nevertheless has incredible predictive power.
And that's the problem with economics and, more specifically, its claims to be a science. Economics has a lot of good theories, but many of them are weak in their predictive power. Why is this?
First of all, there's a data and laboratory-conditions problem. Our view of the economic world is never any more than a partial view and it cannot be controlled: we can't "shock" the system with one event while holding all others steady. And even if we lived in some brave new world where we carried out experiments on people in a controlled fashion, our predictive power might still be poor. People's behaviour may change when they are subject to tests, revealing an element of uncertainty that perhaps feels more at home in Heisenberg's world of quantum mechanics than Einstein's world of relativity.
Second, there's an expectations problem. Inanimate objects generally speaking do not have expectations. People do. Their behaviour often depends as much on what they expect to happen tomorrow as on what is actually happening today. Too often, the policies of well-intentioned governments and central banks have collapsed under the weight of expectations within the private sector that have turned out to be incompatible with subsequent reality. How else can we come to terms with the formation of economic and financial bubbles that ultimately implode?
Third, there's a "model" problem. There may be plenty of good theories around, and all of them may work some of the time, but it is unlikely that any of them work all of the time. Not wishing to paraphrase Abraham Lincoln too far, the fact of the matter is that economic models have sell-by dates. In the 1960s, economists thought they had found how permanently to generate full employment. Their models told them what to do and, for a time, the models worked. But people have a remarkable ability to change their behaviour to take advantage of a model and it wasn't long before the successes of full employment were replaced by the failures associated with high inflation.
I'm sure there are quite a few other difficulties as well. But these three alone are sufficient to suggest that policymakers aren't just push-button scientists, intent on sticking to the conclusions of the models they have derived through the application of rigorous scientific method. Instead, they have to be masters of interpretation, never quite sure what will happen when interest rates go up, or when taxes come down. They cannot be certain that they can reliably use the lessons from the past because those lessons may simply not be relevant. Policymakers are a bit like conductors of orchestras. They have to give a performance that satisfies the public, but they may not be sure of the right interpretation. And even when they've settled on a particular interpretation, they might still find it difficult to drag that interpretation out of potentially unwilling performers.
You might be thinking that this is all rather too philosophical, with little application to the real world. But you'd be wrong. The world is facing a period of rising interest rates - bringing an end to the remarkably low rates of recent years (see left-hand chart). If you use an econometric model, you'll get a straightforward answer as to what happens when interest rates go up. Growth will be a bit lower, inflation eventually lower, bond yields a bit higher, the currency maybe a little stronger... and all to two decimal places, so you can wallow in the comfort of spurious accuracy.
Yet, a glance through recent history suggests that these conclusions are less than reliable. The US looks likely to raise interest rates this year (the Federal Open Markets Committee last week concluded that "policy accommodation can be removed at a pace that is likely to be measured"), so it makes sense to look back at earlier periods in which US rates have gone up. Since the beginning of the 1970s, there have been six occasions in which the Fed has persistently tightened monetary policy. There is only one broad message that can be reached from a quick inspection of these periods. To use the words of Cole Porter, "Anything Goes".
On some occasions, growth has slowed. On others, growth has accelerated. On some occasions inflation has picked up. On others, inflation has come down. Sometimes, the dollar has been strong. Sometimes, it's been weak. And, for those of you that are thinking of switching your savings out of bonds into equities - or, perhaps, out of equities into bonds - all I can say is "good luck". The right-hand chart shows that, on average, equities have given zero excess returns over bonds during periods of monetary tightening in the past 35 years but the range around this average is enormous. In other words, basing an investment strategy on the direction of interest rates alone looks no better a bet than throwing darts at a board with a blindfold on.
Models tend to work on the "ceteris paribus" or "other things equal" principle. The obvious message from past experience is that other things clearly are not equal. There is no such thing as a "standard" economic cycle. It may be true that all economic cycles have a period in which interest rates are rising, but the reasons for higher interest rates are enormously varied.
The policymaking artist has to make a judgement on the context in which interest rates are heading upwards. Sometimes, interest rates start off at a "normal" level and have to head up to abnormal levels because of serious problems with inflation. The UK and US experiences at the beginning of the 1980s surely fit into this category. Then, the economic impact of rising interest rates was brutal.
On other occasions, interest rates start off at an abnormally low level, perhaps because of fears of deflation or of a credit crunch and, ultimately, any subsequent increases prove to be mostly harmless. The Fed's tightening in 1994, for example, might have been very nasty for bond investors that year but, by 1996, both bond and equity investors were beginning to have a thoroughly good time and the US economy was embarking on its late-1990s productivity-led boom.
So what's it going to be this time? The easy answer is that, like the Bank of England already, the Fed is about to raise interest rates back to "normal" levels and, therefore, there is nothing to fear. That, however, may be too simplistic. During periods of abnormally low interest rates, it's quite likely that people begin to behave in rather peculiar ways. In the UK, we've become a nation of property speculators. Certain parts of the US have the same characteristics. If low rates have led to excessive risk-taking, too much speculation and, in some cases, the creation of new financial bubbles, the return to "normality" may prove to be a rather treacherous path.
And, for that reason, it should come as no surprise that on more than one occasion when the Fed has pushed rates up over a period of a year or so, it's been forced into reverse gear shortly afterwards. Rates may be going up this year. But don't let that be the only yardstick by which you judge the outlook for economies and markets over the months ahead.
Stephen King is managing director of economics at HSBCReuse content