Economy is as tricky to forecast as the traffic and weather

Last Monday, the Nobel prize in economics was awarded to Tom Sargent and Chris Sims. Both are well-known macroeconomists and both have worked on economic issues relevant to the 2008 recession and recovery.

Forecasting the future of the economy is tricky business. For one thing it is very complicated, with millions of goods and services changing hands. Another reason is that it is subject to changes in the economic environment that are not economic in nature; weather and politics being two good examples.

Forecasting how the economy will behave requires simplifying models that capture most of its features without adding too much complexity. Over the years, economists have developed increasingly sophisticated ways of doing this.

By way of analogy consider the portion of U.S. Highway 6 that runs between Spanish Fork and Price. I drive this stretch of road on occasion on my way to the San Rafael Swell. The road goes up Spanish Fork Canyon, over Soldier Summit, and down Price Canyon. It is necessarily winding and steep in many places. Suppose you were tasked with forecasting the fate of a convoy of vehicles traveling over this road.

A simple first stab at the problem might involve using elementary physics. The vehicles have given weights, they travel at certain speeds over different portions of the road, the road's gradient and curvature are known.

Based on this information you could, with some effort, derive a forecast for the progress of the convoy.

However, to improve your forecast, you might also consider the weather. Unfortunately, the weather is changeable. You have a general idea of conditions, but the specifics at each point on the road are not known. Furthermore, these conditions can change unexpectedly. You need to make a best guess and factor this into your forecast.

You will also need to update it as the convoy progresses and available information changes. The same principle applies to other factors, such as the mechanical condition of the vehicles, and the mental condition of the drivers.

When you make your forecast you realize that it is only a best guess. It is subject to change due to factors that are difficult to predict.

If you had some control over the highway or the vehicles you might be able to reduce the chances of a serious slowdown or pileup. Suppose you had a radio controller that could uniformly boost or reduce the amount of fuel all the vehicles consume. If conditions looked dangerous you could dial down consumption of gas, slow the convoy down, and reduce the chances of something bad happening.