Academic journal article Independent Review

Who Predicted the Bubble? Who Predicted the Crash?

Academic journal article Independent Review

Who Predicted the Bubble? Who Predicted the Crash?

Article excerpt

Science is prediction.

--Motto of the Econometrics Society

Those who have knowledge, don't predict. Those who predict, don't have knowledge.

--Lao Tzu, sixth-century B.C. Chinese poet

Predicting economic behavior is inherently difficult. As Niels Bohr joked, "Prediction is very difficult, especially if it's about the future." (1) People's economic actions are subject to choice and change, unlike the subject matter of the physical sciences, which has fixed properties. Therefore, the future must remain uncertain. Predicting the economy as a whole is fraught with additional dangers and complications, and all leading indicators of economywide change either do not have or eventually lose the capacity to predict the future accurately. As Paul Samuelson once quipped, "Wall Street indices predicted nine out of the last five recessions" (1966, 92). In light of these difficulties, economists have taken widely divergent positions on prediction.

Many modern mainstream economists, like their colleagues in the physical sciences, view prediction as the essence of science. If you cannot predict with a high degree of accuracy, then you are not being scientific. You must put your science to the empirical test and pass that test. The dominance of positivism in economic methodology encourages economists to worry less about the logical consistency of their models and to concentrate more on the development of models that exploit historical data in making predictions. Government and business economists then use the models to forecast variables such as gross domestic product (GDP), interest rates, unemployment, company sales, stock prices, housing starts, and demographic changes.

There is also substantial support for the position that we cannot predict and that economists have a terrible forecasting record. With respect to the recent bubble and bust, Mike Norman put this view of economists in perspective: "I'm an economist. Big deal, right? Until last year, economists got even less respect than Wall Street analysts; now, we're just a notch above. Admittedly, this reputation is well-deserved, because it comes from our less-than-stellar ability to get economic forecasts right. With all of that data and plenty of powerful computing ability, you'd think we could produce better forecasts. Heck, even the local weatherman puts us to shame" (2003).

The "street," having witnessed countless forecasts go wrong, is naturally suspect. As Lindley Clark once noted in the Wall Street Journal, "Economists have a great deal of trouble predicting the future, and it's unlikely that this unhappy situation ever will change" (1990). Indeed, some economists think that forecasts are akin to "magic" and that such magic is contradicted by the very essence of economic science. Deirdre McCloskey has expounded on this view of economic forecasts:

   Economics is the science of the postmagical age. Far from being
   unscientific hoobla-hoo, economics is deeply antimagical. It keeps
   telling us that we cannot do it, that magic will not help. Only the
   superstitious think that profitable forecasts about human action are
   easily obtainable. That is why economics, contrary to common sneer,
   is not mere magic and hoobla-hoo. Economics says that forecasts, like
   many other desirable things, are scarce. It cannot be easy to know
   what great empire will fall or when the market will turn. "Doctor
   Friedman, what's going to happen to interest rates next year?"
   Hoobla-hoo. Some economists allow themselves to be paid cash money
   to answer such questions, but they know they cannot. Their very
   science says so. (1992, 40)

Though agreeing in the main that forecasting has questionable value, Michael Bordo (1992, 47) claims that forecasting has some scientific and practical value and is not all just snake oil and magic. He notes that not all economists have been such dismal failures as forecasters: Richard Cantillon made correct predictions about John Law's Mississippi Bubble system based on economic theory, and he made a fortune as a result. …

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