When I studied economics I learned about least squares regression. Later when I took an interest in market behavior I learned about technical analysis and the Elliott wave theory. It may be that the Elliott wave theory is better at explaining our economy and may provide better guidance for economic policy.
The least squares regression takes a series of data points and draws the best fitting line through them. Once you know the formula for the line it is easy to project the trend into the future. This technique is used extensively in economic forecasting.
Here is a chart from Wikipedia and its article on this.
This approach assumes (ass u me) economies will grow continuously and forever. Economic policy then should try to smooth the data points so that they are all on the line.
I am not a total believer in the Elliot wave theory but I do like that it shows markets as being fractal and moving in a series of ups and downs. Here is a chart from Elliot himself and the link to the Wikipedia entry.
It seems to me this is a more realistic way to view the economy. Clearly the economies with which we are most familiar have had ups and downs and this has been happening for millennia with the rise and fall of civilizations. It would be nice if we could be the exception but probably our turn will come.
One of the features of these waves are that they are fractal which means that with in each trend there is another whole series but on a shorter time scale and each trend itself may be just a small part of a larger trend.
This fractal nature of markets, and the economy, make forecasting extremely difficult although there is a concept of fractal dimension which can be calculated. Noting when fractal dimension changes for different time series may help with predictions.
Now to economic policy.
If one can accept the least squares method of forecasting the policy is easy. When there is a down trend you apply lots of government stimulus spending and when there is an up trend you try to slow things a little.
Policy if one accepts the wave theory is more difficult. We may be able to detect some of the turning points but we don’t know which fractal we are on or how severe the down trend is likely to be.
The policy during a downtrend depends upon the severity of the trend and should be a generally cutting back of living standards. The question is who should make the cutbacks. Generally it should be everybody except me. The sad thing is that cutbacks apply mostly to the poorer segments of society. If you happen to be a government employee you don’t have to worry too much – yet.
The danger is that if we apply stimulus going into a major down trend, we are likely to bring forward and make worse a major crash.
Wouldn’t it be nice if the least squares approach were the one?