Thursday, 9 May 2013

The Truth About Economic Forecasting

Guest post by Graeme B. Littler

Astrologers, palmists, and crystal-ball gazers are scorned while professional economists are heralded for their scientific achievements. Yet the academics are no less mystical in trying to predict the direction of interest rates, economic growth, and the stock market.

Sixty-five years ago, Thomas Dewey was defeated by Harry Truman in the US presidential race, stunning the political experts and journalists who were certain Dewey was going to win. While questions about “scientific” polling techniques naturally arose, one journalist focused on the heart of the matter. In his November 22, 1948, column in Newsweek, Henry Hazlitt said the “upset” reflected the pitfalls of forecasting man’s future. As Hazlitt explained:

The economic future, like the political future, will be determined by future human behaviour and decisions. That is why it is uncertain. And in spite of the enormous and constantly growing literature on business cycles, business forecasting will never, any more than opinion polls, become an exact science.

[We know how “well” they forecast both the Global Financial Crisis, and the recovery therefrom.] We know how well economists forecasted the eighties: from the 1982 recession and the employment boom to the Crash of 1987, no major forecasting firm came close to predicting these turns in the market. And following that Crash, virtually every professional forecaster revised his economic forecasts downward, all because the historical data suggested that the stock market was a reliable barometer of future economic activity. The economy then continued to expand and the stock market eventually reached newly inflated highs.

Rockwell Jr., Llewellyn H.

Despite the sorrowful record, most economists remain die-hard advocates of forecasting. Most have spent years in college and graduate school learning the tools of their trade, and can’t bring themselves to admit their own entrepreneurial errors. As one investment advisor put it:

No matter how many times they fail, their self-assurance never weakens. Their greatest (or only) talent is for speaking authoritatively.

Of their errors, the forecasters contend that it’s only a matter of time before they master the techniques. Though that day will never arrive, economic forecasting remains an integral part of the economics mainstream. The original motto of the Econometric Society still holds sway: “Science is Prediction.”

Whether one uses a ruler to extend an economic trend into the future, or a sophisticated econometric model with dozens of equations, the problem is still the same: there are no constant relations in human affairs.

Unlike the natural sciences, economics deals with human actions, plans, motivations, preferences, and so on, none of which can be quantified. Even if it were possible to quantify these things, changing tastes (and all the factors that affect tastes) would make the data almost instantaneously useless to the forecaster. And then there are the millions of “unimaginable” things which constantly crop up, influencing people in unpredictable ways—like Eisenhower’s heart attack (after which the stock market experienced a massive drop), or the recent outage in the Bitcoin server (after which the Bitcoin price plummeted), or Saddam Hussein’s tanks driving into Kuwait (tweaking the tail of an already delicate world economy, sending it within weeks from tiger into tailspin).

Economic statistics (i.e., history) do not imply anything about the future. Because data show the relation between price and supply to be one way for one period of time doesn’t mean that it cannot change. As Ludwig Von Mises pointed out,

external phenomena affect different people in different ways [and] the reactions of the same people to the same external events vary.

Some economic forecasters like to argue that economic forecasting is not unlike predicting the weather (and should also be equally difficult). Not only is the nature of these two problems entirely different, but one can reasonably expect that as scientific methods become more sophisticated, weather prediction could theoretically approach perfection. This is because there are constant relations among physical and chemical events. By experimenting in the laboratory, the natural scientist can know what these relations are with a high degree of precision. However, human society is not a controlled laboratory. This fact makes the forecaster’s job of accurately predicting future events impossible.

Forecasters try to get around this problem by linking events in historical chains, and randomly guessing that if one variable reoccurs, then the others will necessarily follow. But this is a sophisticated version of the logical fallacy, post hoc ergo propter hoc (after this, therefore, because of this). This has led major forecasters to seriously study astrological patterns and to build mathematical models correlating weather patterns with business cycles. Once the forecaster throws out economic logic and causality, anything could have caused anything else and all variables in the universe are open to study. One mainstream forecasting theory for investors, for example, is based on the rate at which rabbits multiply.

Does this mean we can know nothing about the future? No, the best “forecasters” are successful businessmen,* whose entrepreneurial judgment allows them to anticipate consumer tastes and market conditions. As Murray N. Rothbard points out:

The pretensions of econometricians and other “model-builders” that they can precisely forecast the economy will always flounder on the simple but devastating query: “If you can forecast so well, why are you not doing so on the stock market, where accurate forecasting reaps such rich rewards?”

Forecasting gurus, instead, tend to disdain successful entrepreneurs—just as politicians and planners do, preferring to write the entrepreneur out of their thinking and rely instead on the quacks.

The myth that economists can predict the future is not just harmless quackery, however. Central planners use the same theories to direct the economy. Yet by setting production goals with the data collected by the planners themselves, they destroy the very process that directs free-market production.

Central planners try to overcome uncertainty by substituting formulas for entrepreneurial judgment. They believe that they can replace the price system with commands, but they miss the whole purpose of individual action on the free market. As Ludwig von Mises said, they make “not the slightest reference to the fact that the main task of action is to provide for the events of an uncertain future.” In that sense, central planners are no different from professional forecasters.  [Even in better times, however, not with very much success. – Ed.]

Don’t expect unemployment among forecasters, however. Many have cushy jobs with Treasury, the Reserve Bank, and virtually every agency, arm and consultancy of government, and will happily issue predictions without end.

In the view of Austrian economists, on the other hand, economists have three functions: to further our understanding of market processes, to identify possible consequences of government policies, and to counter economic myths.

Economic forecasting has nothing to do with these objectives. In fact, by presenting itself as the only scientific dimension of economics, forecasting has helped discredit the whole discipline, and fuelled an exodus of economists from the more mundane academic world to the arena of state control and coercion, to the detriment of every American.

Graeme B. Littler is a former bank economist and editor of Central Bank Watch, and now scholar in residence at the Ludwig von Mises Institute's Lawrence Fertig Student Center. This article from the Mises Daily first appeared in the book Economics of LibertyIt has been updated, localised and lightly edited.

Photoshopped picture of Ludwig Von Mises by Peter J. You can easily tell it’s been photoshopped, because the fastidious Von Mises never wore a T shirt in his life--let alone use “cuss words” like that!

NOTES:

* Unlike politicians and central planners, who do take these forecasts as gospel (and Ben Bernanke, Alan Bollard, Graham Wheeler et al who think they write the gospel) entrepreneurs themselves rely largely on their own independent judgement of what the future holds-- and it's them after all who actually move the economy and drive production. 
    Entrepreneurs will certainly listen to forecasters, and they definitely don't mind forecasts being taken seriously by the easily led, since it sets up opportunities to take advantage of their poor estimates.  ( What entrepreneurs are often looking for is, as Israel Kirzner explains, "unexploited opportunities for reallocating resources from [low-valued] use to another of higher value [which] offers the opportunity of pure entrepreneurial gain.  A misallocation of resources occurs because, so far, market participants have not noticed the price discrepancy involved.  This price discrepancy presents itself as an opportunity to be exploited by its discoverer.  The most impressive aspect of the market system is the tendency for such opportunities to be discovered.")
    Entrepreneurs generally recognise the truth stated by Ludwig von Mises, "that the main task of action is to provide for the events of an uncertain future."  If, for example, the date of booms and busts and the like could be predicted "with apodictic certainty" according to some formula or other, then everyone would act at the same time to make it so.

    In fact, reasonable businessmen are fully aware of the uncertainty of the future. They realize that the economists do not dispense any reliable information about things to come and that all they provide is interpretation of statistical data from the past...   
    If it were possible to calculate the future state of the market, the future would not be uncertain.  There would be neither entrepreneurial loss nor profit.  What people expect from the economists is beyond the power of any mortal man.

The greatest danger of 'the forecasting delusion' is the illusion that "the future is predictable, that some formula could be substituted for the specific understanding which is the essence of entrepreneurial activity, and that familiarity with these formulas could make it possible for [bureaucratic management] to take over the conduct of business."

    The fact that the term 'speculator' is today used only with an opprobrious connotation clearly shows that our contemporaries do not even suspect in what the fundamental problem of action consists.
    Entrepreneurial judgment cannot be bought on the market. The entrepreneurial idea that carries on and brings profit is precisely that idea which did not occur to the majority. It is not correct foresight as such that yields profits, but foresight better than that of the rest.

4 comments:

  1. "In fact, by presenting itself as the only scientific dimension of economics, forecasting has helped discredit the whole discipline, and fuelled an exodus of economists from the more mundane academic world to the arena of state control and coercion, to the detriment of every American."

    Two points 1) very few economists are involved in forecasting. The majority of economists have nothing to do with it and want nothing to do with it. 2) private forecasters stay in business only because someone is buying their forecasts. There are entrepreneurs out there buying forecasts. One assumes this is because they find the information they get from these forecasts worthwhile.

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  2. If predictions are impossible in economics, how can you justify having any opinion on economic policy? How can you defend your belief that, for example, tax increases will hurt the economy, without making economic predictions?

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  3. Sam, the economy is not a real existant entity. Each person you ask will possess a different delusion of what it is. On the other and individuals are real. You can touch them. Deal with the real. To answer your question about tax you ought to direct your atention away from an imaginary collective and deal with what exists. Deal with individuals. Ask yourself whether it would help an individual to have more of his property stolen from him or less or even noen at all. The answer will certainly let you know whether taxing is a good thing to do or not.

    Amit Cim

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  4. Sorry, but when we think about how millions of individuals will respond to a set of circumstances, we're making economic predictions.

    Humans are complex, but (especially on aggregate, ie, in an economy), predictable, even when they act irrationally.

    I would suggest that the failure of economic predictions lies in this irrationality for two reasons:
    - economic models usually assume people are impossibly rational
    - economists, as humans, are sometimes irrational, so they are liable to let what they'd like to be true get in the way of the evidence. This is true on the left and the right

    ReplyDelete

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