Not Prediction But Explanation

Her Majesty Queen Elisabeth II asked why economists did not predict the current economic troubles. The British academic community (and some in the American) is using this opportunity to discuss views on the nature and limits of contemporary macroeconomics. This is very useful.

Peter Boettke over at The Austrian Economics summarizes and discusses some of the main issues. I shall not repeat what he says in my post. Everyone should read Pete’s.

It is convenient for those of us who never thought much of contemporary macroeconomics to support the complaints that the financial crisis and recession was not “predicted” by the Macroeconomics Top Brass. But, as tempting as it is, it would be a mistake.

Most economists use the word “prediction” carelessly. They usually really mean “retro-diction.” This is the use of models to rationalize past events. We construct a model and then see if we had the model before the events whether it would it have literally predicted them. If so, then economists would say that this model is supported by the data.

But prediction in the way laypeople mean it is called forecasting. We construct the model before the events and then see it literally predicts the future state of economic variables.

While there is a lively business in economic forecasting, it is a very crude endeavor. No economic model, past, present or future, will do well here. This is because there are many radically unpredictable (in the lay sense) elements in human decisionmaking.

One important argument in this regard was made by Sir Karl Popper in The Poverty of Historicism (also endorsed by economists George Shackle and Ludwig Lachmann). Adapting the argument for our current purposes:

1. The course of economic events is strongly influenced by changes in the contents of the human mind that is, the future course of knowledge. This includes what we would call knowledge of the external world and of ourselves.

2. We cannot predict, by rational or scientific methods, the future course of knowledge (in the sense of reasonable conjectures that we will have in the future or even in the sense of our moods – animal spirits).

3. This is because if we could predict future knowledge it would not be future, but present. No one believes that we know now everything we will know in the future.

4. Therefore, we cannot predict the future course of economic events.

There is a lot here but we are just summarizing.

Nevertheless, it captures an important point. We are dealing with something fundamental about the human condition and not specifically the rational expectations or efficient markets hypothesis. Those who are dancing on the grave (if it be so) of efficient markets should stop. If we drop efficient markets (in all forms – weak, moderate, strong and even an Austrian version of a tendency toward error correction) we will not get closer to the forecasting ideal. That would not be science but prophecy.

Nevertheless, we have the right to expect that a good macro-monetary theory would at least warn us ex ante that something dangerous is going on and ex post provide a reasonable explanation of what happened. The ex ante warning could be looked at as an example of what F.A. Hayek called “pattern prediction.”  I believe that in a variety of its forms (old or new) Austrian theory provided both the ex ante warning and a now a reasonable ex post explanation of what happened.

The intellectual tragedy in all of this is that there will not be any major reassessment of the methods and focus of modern macroeconomics. This includes any reassessment of the Austrian approach. Why not? The commitment to scientism is too strong. In a previous post I discussed this.

A refreshing exception is the letter by Geoffrey Hodgson and other distinguished British economists complaining about the training of economists. Quoting the letter in part:

“In 1988 the American Economic Association set up a Commission on the state of graduate education in economics in the US. In a crushing indictment published in the Journal of Economic Literature in 1991, the Commission expressed its fear that ‘graduate programs may be turning out a generation with too many idiot savants skilled in technique but innocent of real economic issues.’

Far too little has since been done to rectify this problem. Consequently a preoccupation with a narrow range of formal techniques is now prevalent in most leading departments of economics throughout the world, and notably in the United Kingdom.”

It is true that the letter also endorses the views of others that economists were too “charmed” by the market, etc. and that is why they failed to see what was coming. But the letter rightly emphasizes the poor training of economists. I hope we do not have to wait for all the formalists to die ( Recall Schumpeter’s point about how economics changes) for there to be real change.

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