Wall Street breathlessly awaits the newest payrolls report, which is widely held to contain the information needed for the FOMC to decide whether or not it should raise the overnight interbank lending rate from zilch to zilch plus a few basis points later this month.
The payrolls report is going to be revised umpteen times after its initial release, is in many ways driven by statistical artifacts (such as the “birth-death” model) and concerns a lagging economic indicator – in other words, its “signal to noise” ratio makes it utterly useless, even if one erroneously ascribes a lot of meaning to economic statistics describing the past.
Change in monthly non-farm payrolls in 1000ds, via Saint Louis Federal Reserve Research, click to enlarge.
And yet, this utterly devoid of informational content data point is what the central planning bureaucrats are held to need to decide on their next steps in terms of interest rate manipulation! We are continually surprised by the fact that people can discuss this obvious nonsense with a straight face.
In this context we have recently come across an interesting article at Forbes, by sound money and free market advocate Ralph Benko. It is entitled “If The Fed Is Always Wrong How Can Its Policies Ever Be Right?” and is well worth the read. As Mr. Benko points out, the Fed’s economic forecasts leave a lot to be desired, primarily because they tend to be dead wrong with unwavering regularity.
He proceeds to ask how a bureaucracy that couldn’t forecast its way out of a paper bag can possibly know what policies it should implement. It seems totally absurd to expect it to be able to ever get it right, except perhaps by sheer accident.
Mr Benko inter alia quotes from F. A. Hayek’s famous Nobel Prize speech “The Pretense of Knowledge” (a speech that may have made his hosts regret their decision to award him the prize):
“We have indeed at the moment little cause for pride: as a profession we have made a mess of things. It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences — an attempt which in our field may lead to outright error.
It is an approach which has come to be described as the “scientistic” attitude — an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.” I want today to begin by explaining how some of the gravest errors of recent economic policy are a direct consequence of this scientistic error.”
Friedrich Hayek, critic of “scientism” in economics
Hayek simply reminded everybody that economics is not akin to the natural sciences and that the attempt to apply the methodologies of the natural sciences to economic problems is therefore bound to lead to nothing but error. We term this tendency “physics envy” – economists want their science to be as “precise” as physics, and are employing mathematical models in the attempt to attain this precision. It seems to us that all of this is based on a fundamental misunderstanding of what economic science actually is.
We certainly do not agree with those who say that economics is a “pseudo-science”, i.e., that it isn’t a science at all. It has become fashionable for critics of the current economic dispensation to make statements to this effect, but they err. Economics is a social science, and as such is certainly fundamentally different from the natural sciences, but that doesn’t mean it isn’t a science. If one insists on averring that economics isn’t a science at all, one implicitly denies the existence of economic laws. However, economic laws do exist, and it can be shown that they do.
Hayek was critical of the “pretense of knowledge” as evidenced by the methods modern-day economists employ to determine the proper course of “economic policy”. He surely didn’t mean to indicate that there is nothing for economists to know, only that what they actually can know is vastly different from what they nowadays pretend to know. As Murray Rothbard noted in his foreword to Ludwig von Mises’ great work on methodology, Theory and History:
“Mises saw that students of human action are at once in better and in worse, and certainly in different, shape from students of natural science. The physical scientist looks at homogenous bits of events, and gropes his way toward finding and testing explanatory or causal theories for those empirical events. But in human history, we, as human beings ourselves, are in a position to know the cause of events already; namely, the primordial fact that human beings have goals and purposes and act to attain them. And this fact is known not tentatively and hesitantly, but absolutely and apodictically.”
(italics in original)
In other words, economists in a sense have an advantage over natural scientists, in that they have apodictic knowledge of the cause of economic events from the outset – they don’t need to conduct (and indeed, cannot conduct) falsifiable experiments to “test” the laws of economics. On the other hand, they are also at a disadvantage, as the uniqueness and complexity of every slice of economic history makes historical statistics and data entirely useless for the formulation of economic theory. As Rothbard said ibid. on the problem with “empiricism”:
Is the fact of human purposive action “verifiable”? Is it “empirical”? Yes, but certainly not in the precise, or quantitative way that the imitators of physics are used to. The empiricism is broad and qualitative, stemming from the essence of human experience; it has nothing to do with statistics or historical events. Furthermore, it is dependent on the fact that we are all human beings and can therefore use this knowledge to apply it to others of the same species. Still less is the axiom of purposive action “falsifiable.” It is so evident, once mentioned and considered, that it clearly forms the very marrow of our experience in the world.”
Murray Rothbard – the empiricism of economics is qualitative, not quantitative
Socialism as Institutional Aggression Against the Free Exercise of Human Action
If you look at the comments section at the Forbes article mentioned above, you will inter alia find a brief comment by us. We made the following remark:
“[…] the very notion that there should be a “policy” is already mistaken. It is just as mistaken to assume that the science of economics is about making “predictions”. It isn’t, and it will never magically get better at this task.”
Regular readers are no doubt aware that we believe central planning by a monetary authority to be superfluous and harmful. As we have pointed out on numerous occasions, central banks represent a special case of the socialist calculation problem (see e.g. “Sell ’em All! Central Banks and the Socialist Calculation Problem” for some background on this).
This is based on an idea first formulated by Jesus Huerta de Soto as far as we are aware, who has proposed to broaden the scope of the socialist calculation problem originally presented by Mises. In his own work on socialism – ‘Socialism, Economic Calculation and Entrepreneurship’ – de Soto makes the case that one should actually broaden the scope of what the term socialism itself means.
While Mises defined socialism very narrowly – namely as a system in which the State is the sole owner of the means of production – de Soto tries to incorporate the ideas of Hayek, Kirzner and others on the topics of economic calculation, knowledge and entrepreneurship to arrive at a definition that probably has more practical applicability in modern times, i.e., the era after the collapse of the communist system. He writes:
“Our expressed desire to apply subjectivism with the greatest possible rigor and consistency to the analysis of socialism manifests itself, above all, in our definition of this social system. Indeed, we have already stated our view that the core, or most characteristic feature, of human nature is the ability of all people to act freely and creatively. From this standpoint, we consider that socialism is any system of institutional aggression on the free exercise of human action or entrepreneurship.”
(italics in original)
Jesus Huerta de Soto: a broader definition of socialism
One can certainly agree that central banks fall within the scope of this definition: their actions do represent a form of “institutional aggression on the free exercise of human action or entrepreneurship”, as they manipulate interest rates which would otherwise form freely in the market.
Economics and Prediction – Historians of the Future
However, we want to briefly focus on the second part of our comment at Forbes, concerning economics and “prediction”. Modern critics of economics are very much focused on this point, as it can be shown again and again that economists as a group are almost uniquely unable to make correct economic forecasts. They are on average worse at predicting the future course of the economy than house wives (there actually exists a study conducted by the Economist magazine that has compared the economic forecasts of house wives to those of professional economists over a period of ten years and has come to the same conclusion).
And they have to grin and bear the critique, because they themselves have invited it with their “scientistic” approach to economics. The original motto of the US Econometric Society was “Science is Prediction”. By implication, if economic science is incapable of furnishing correct predictions, it cannot be a science. Hence the widespread accusation that “economics is not a science”. In this case however, it is the motto that is mistaken.
Economic theory cannot be “advanced” by the application of mathematics and statistics.
Unfortunately, human beings are not “predictable”. They continually soak up new knowledge as it emerges, their value scales are in no way “fixed” and their actions are based on future states of knowledge that are simply not known yet. A physicist can tell us precisely where a rock we have thrown will land, provided he is made aware of all the necessary data – all of which can be precisely measured. He doesn’t have to worry that the rock will change his mind in mid-flight, mainly because the rock has no mind. Human beings – most of them, anyway – do have minds.
The premise that economics should be based on some variant of positivism – i.e., that it should employ “data” and “statistics” and use them to make “predictions” is fundamentally erroneous. Not only is this simply impossible, it is not even the task of economics. As Mises noted, economics is essentially the best elaborated part of the broader science of human action – which used to be called “sociology” before Mises renamed it praxeology (he didn’t do this lightly) due to the anti-economics stance embraced by most sociologists in his time.
Einstein stumbles on an economic law by accident
As such, the task of economics is to elaborate economic laws. This is done by logical deduction based on the action axiom. Within reason, it is not only legitimate, but necessary to employ models in economic theorizing. These allow economists to create a simple world with numerous so-called “ceteris paribus” conditions, to which new conditions are then added in a step-by-step process. For instance, the model of the evenly rotating economy (an economy in “equilibrium” that can never exist in the real world) is extremely useful in explaining how savings, investment and interest rates affect the economy’s structure of production.
Economic theory, i.e. the body of economic laws, can be used to explain economic history – but the reverse cannot be done, i.e., economic history cannot possibly serve to construct economic theory. Economic predictions are in a way akin to the task of a historian rather than that of an economist. The study of history requires that the historian employ the known data, as well as the knowledge provided by other scientific theories, but it ultimately goes beyond that.
Mises referred to this as the “understanding” of the historian. When e.g. discussing important historical personalities such as Julius Cesar, it won’t be enough to merely consider the documentary evidence from Cesar’s time. What were Cesar’s motives? Why did he act the way he did? This is where understanding comes in. When economists make predictions, they are no longer wearing the hat of the economist – instead, similar to speculators in the stock market – they become “historians of the future” as Mises put it.
Alea iacta est – Cesar crosses the Rubicon – but why did he do that?
To be sure, economists should have an advantage over others when engaging in economic prediction. As long as they are aware of sound economic theory, they can use their theoretical knowledge as a constraint on their predictions. In that sense, economic predictions are certainly not a completely useless effort (we are obviously not speaking of popular guessing games such as whether next month’s CPI reading will be “0.2%” or “0.3%”). However, economists should be aware that when making predictions, their knowledge of economic theory can at best help them to exclude certain outcomes and refine those that remain.
Thus they can at most hope to make correct qualitative forecasts, but not quantitative ones. An example would e.g. be the following: “We predict that the suppression of interest rates and the enormous amount of money printing instigated by central banks will eventually lead to a major bust, because we know with certainty that it has led to massive capital malinvestment.” An example of a completely useless (and likely wrong) forecast based on the same data points would be: “We predict that GDP will contract by 4.3% in Q2 2017”.
Most modern-day economists are primarily making forecasts of the second kind these days, a result of the “scientism” error discussed above. It is no wonder that they are continually ridiculed for this. They deserve it.
If one considers that the next major interest rate manipulation by the Fed appears to hinge on a notoriously unreliable report about a lagging economic indicator, it should immediately become clear on what a flimsy foundation modern central economic planning rests. How much more ridiculous can it possibly get?
Incidentally, it also serves to demonstrate how far off the reservation economists have veered in their desperate and laughable attempts to transform economics into a discipline akin to the natural sciences. They have swallowed Milton Friedman’s arguments on positivism in economics hook, line and sinker. This is one area of economics in which Friedman couldn’t have been more wrong.
The debate over proper economic methodology and the epistemological problems of economics deserves to be revived (readers interested in these problems should take a look at this collection of essays by Mises on the topic). Economics is an aprioristic science, not an empirical one. For all their sophistication, the makers of the DSGE models on which the central planners base their decisions are ultimately simply “groping in the dark”.