Do Bad Forecasts Mean Bad Economics?

Proper methodology is often debated in economics. Inevitably, one side points out that the other side has made some very embarrassing predictions. Pro-market folks love to reference WWII era Keynesians who thought that the United States would go back into depression after the government stopped spending vast amounts of money on war goods. As it turns out, the economy boomed after the war. Pro-government folks respond by pointing out that while Austrians may have identified this recession, they have predicted many other bubbles, recessions, and downturns that failed to transpire. How relevant are these comments?

Economic theory must be derived from axiomatic knowledge of human action, the ultimate causal factor. From here, economists must use deductive reasoning to establish economic laws, like marginal utility, supply, demand, etc. This is the foundation of economic theory.

Economists must also be able to apply these theories to the real world; otherwise they’d be useless. Essentially, can the historical (empirical) facts square with the theory developed? If not, economists have to reassess their assumptions and reasoning, as well as the historical facts.

Positivism (popularized in economics by Milton Friedman) is a rejection of this methodology. Essentially, it inverts the order of theory and history. Laws must be derived from historical data, as in the natural sciences. The problem with applying positivism to economics, as pointed out by Mises in The Ultimate Foundations of Economics, is that it fails to account for human finality, or choice of ends. Humans choose their ends, which influences their action. Do rocks or galaxies choose what they do? Thus, the proper method for developing economic law must account for human volition, which positivism cannot.

But where does forecasting enter? It is true economists use their theories to make predictions. If they are wrong, does that mean their theory is also wrong? Not necessarily. They could have been acting on bad information, or they might have failed to account for the proper causal factors. Just because economists have bad predictions doesn’t necessarily mean their theory is bankrupt. If that were the case, than all serious economic theories would be wrong.

The proper way to discredit a theory is on logical grounds. Are the assumptions correct? Is the logical chain connecting the assumptions and the results correct? If a theory does not match reality, than the theory could very well be wrong and this occurrence demands investigation.

The ultimate reality that all economic theory must conform to is human action. If any theory’s assumptions marginalize human’s choice of ends, uniqueness, etc, it is more unrealistic than all the various theories that have not passed quantitative muster.

“The embarrassing fact that the forecasts of would-be economic sooth-sayers have always faced an abysmal record, especially the ones that pretend to quantitative precision, is met in mainstream economics by the determination to fine-tune the model once more and try again. It is above all Ludwig von Mises who recognizes the freedom, of mind and of choice, at the irreducible heart of the human condition, and who realizes therefore that the scientific urge to determinism and complete predictability is a search for the impossible – and is therefore profoundly unscientific.”

Murray Rothbard, in the preface to Theory and History by Ludwig Von Mises.

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8 Responses to Do Bad Forecasts Mean Bad Economics?

  1. Lord Keynes January 22, 2012 at 12:10 pm #

    “Pro-market folks love to reference WWII era Keynesians who thought that the United States would go back into depression after the government stopped spending vast amounts of money on war goods. As it turns out, the economy boomed after the war. “

    (1) The belief that the post-WW II boom after 1946 in any way “refutes” or “contradicts” Keynesian economics is totally false.

    http://socialdemocracy21stcentury.blogspot.com/2011/07/post-1945-boom-in-america.html

    (2) There was indeed a technical depression after the war: in 1945 US GDP fell by 12.5% between February and October.

    (3) The notion of post-war depression or stagnation after the conversion of the economy from its wartime state was completely rejected by John Maynard Keynes. So even your reference to “WWII era Keynesians” is grossly misleading. What kind of analysis of what “WWII era Keynesians” said ignores what Keynes — the founder of Keynesian economics — thought about this question?

    • krlatham January 22, 2012 at 12:59 pm #

      Thanks for the comment, here are my thoughts.

      1) I agree that the episode following WWII does not discredit Keynesian economics, although for different reasons. In the spirit of the post, economic theory is fundamentally proven deriving propositions from human choice. So I see Keynesian economics being wrong for various other reasons, not specifically that historical episode. Perhaps I could have been more clear in the post. After certain economists make various predictions which do not materialize, the economists can look back to the situation and reassess what happened and fit the event in terms of their theory. It happens all the time, people are wrong, so they point out assumptions they missed, factors they discounted, etc. They rarely change their whole paradigm. Real debates on economics must focus on connecting key assumptions of various systems to human action. So I agree, when people on either side point to failed predictions of the other side they do not substantively add to the real debate.

      Even so, I find the way Keynesians corrected themselves after WWII unsatisfactory. Rather than rehash that whole debate here, here is the article that best describes the problems with that story. (http://econstories.tv/wp-content/uploads/2011/05/The-Great-Depression-of-1946.pdf) The relevant section is “Assessing the Keynesian Interpretation” which begins on page 18.

      2) Interesting, but I don’t buy the story that an economy is simply a GDP-factory. The very fact there was a downturn in GDP not matched by massive unemployment and the like indicates there is more to prosperity than GDP growth.

      3) Point taken, Keynes himself was above making the error. That does not change the fact his disciples in America, like Alvin Hansen and Paul Samuelson, were wrong.

      I would be interested to learn what you think about proper methodology , especially since we could spend days pointing out the various problems of each other’s explanation the post WWII boom without really getting at the heart of the issue.

      • Lord Keynes January 22, 2012 at 2:21 pm #

        First, let me say, I did enjoy reading your post, and you raise important questions that require answers, questions which I also take very seriously.

        “Even so, I find the way Keynesians corrected themselves after WWII unsatisfactory. “

        And yet Keynes and those Keynesians who followed him in his prediction of no stagnation after WWII did not need to “correct” themselves. They were right – Keynes made a prediction before the event that turned out to be true.

        “I would be interested to learn what you think about proper methodology , especially since we could spend days pointing out the various problems of each other’s explanation the post WWII boom without really getting at the heart of the issue”

        The apriorism of Mises in his praxeology is a wholly unaccepable and flawed methodology for economics:

        http://socialdemocracy21stcentury.blogspot.com/2010/10/mises-praxeology-critique.html

        The proper method for economics requires both deduction and induction, with a strong empirical approach.

        In his repect, Hayek’s rejection of Mises’s apriorism and Hayek’s attempt to adopt a broadly empircial, Popperian method for economics is essentially correct – or at least a step in the right direction:

        http://socialdemocracy21stcentury.blogspot.com/2011/05/hayek-on-mises-apriorism.html

        The question whether induction is useful and can be justified rationally goes well behind economics:

        http://socialdemocracy21stcentury.blogspot.com/2010/12/risk-and-uncertainty-in-post-keynesian.html

        “2) Interesting, but I don’t buy the story that an economy is simply a GDP-factory. “

        And yet the only Austrian substitute measures of output (in place of GDP) like Rothbard’s Gross Private Product are also aggregates, not fundamentally different from GDP, except they remove G.
        Without a measure of output the whole attempt to analyse an eocnomy collapses: for how could you know whether Keynesian stimulus or Austrian liquidationism have the effects alleged claimed for them, without looking at real output in some aggregate form?

        Even Mark Skousen’s appeal to “Gross Output (GO)” – which is intermediate Input plus GDP – as a more accurate measure of national output is nothing but an official Commerce department aggregate measure of output too.

        http://www.mskousen.com/2001/04/beyond-gdp-a-breakthrough-in-national-income-accounting/

        In The Structure of Production, Skousen attempted to create a new output statistic: Gross Domestic Output (GDO), as his “Austrian” alternative to GDP. However, he seems to regard Gross Output (GO) as an acceptable version of this.

  2. krlatham January 24, 2012 at 4:17 pm #

    Your first few links are essentially a bibliography that corresponds to my “To Read” list. My concerns are that
    1) The use of empirics in Misesian praxeology is not useless, they simply cannot verify economic theory. Obviously empirical data and theory share a relationship, the question is which is superior.
    2) Mises admits synthetic propositions in his deduction, true, but the emphasis should be placed on their nature, whether qualitative or quantitative. More importantly, and much to my shame, I’m not entirely aware of the specific instances Mises admits this. The charges by Caldwell and Blaug are on my reading list. Furthermore, other Austrians (I’m remembering Rothbard admitting certain points were based on experience to further his analysis In MES) have added empirical assumptions into their reasoning chains. It doesn’t mean that the analysis in now cancerous, its just an extension of theory by assuming certain conditional assumptions.
    3) I’m still unsure if the whole argumentation about Mises’ methodology is sufficient. Mises may have made synthetic appeals, but those specific appeals would have to be proven false, not highlighted, to discredit his methodology.

    In the second portion, I agree that Rothbard and others aggregates are similar to GDP, my point is “so what if there was a ‘technical depression’ based on GDP numbers?’ GDP growth is a simplistic proxy for economic health, especially if GDP growth fell in 1945 while other relevant factors were fine.

    Before belaboring your critiques on Mises’ praxeology, please understand I’m well aware I’m under-prepared and doing the necessary research as we speak. Thanks for the links though: very well organized with impressive bibliographies.

  3. Elliott February 5, 2012 at 4:39 am #

    In his repect, Hayek’s rejection of Mises’s apriorism and Hayek’s attempt to adopt a broadly empircial, Popperian method for economics is essentially correct – or at least a step in the right direction:

    facepalm — no no no — it’s a long jump in the wrong direction —

    — the other Hans takes care of this — start here

    http://www.youtube.com/watch?v=BojfG6fmYEU

    http://mises.org/books/esam.pdf

  4. Elliott February 5, 2012 at 4:56 am #

    more from hoppe — on the above video in my prior comment at 12:50 you can get your popper on

    Richard von Mises, the originator of the frequency interpretation of probability, has unambiguously stated: the application of the term probability to a single event is “utter nonsense.” — Hoppe

    It is possible to speak about numerical probabilities only in reference to a properly defined collective. But ontologically, no such collective exists as far as human actions are concerned. Each human action must be considered a unique event, constituting a class of its own. The method of Verstehen through verbal communication represents a technique of synchronic as well as diachronic individualization. By means of Verstehen each actor (and each group of actors) can be dehomogenized from any other actor (or group) and every given actor (or group of actors) today can be dehomogenized from the same actor (or the same group) tomorrow. Or in the words of Richard von Mises, Verstehen provides us with a “selection rule” which prohibits every use of “relative frequency” statements, because, by definition, relative (numerical) frequencies require a class made up of more than just one element. — Hoppe

    A MUST READ — THE LIMITS OF NUMERICAL PROBABILITY:
    FRANK H. KNIGHT AND LUDWIG VON MISES
    AND THE FREQUENCY INTERPRETATION — hans hoppe
    http://mises.org/journals/qjae/pdf/qjae10_1_1.pdf

    http://www.youtube.com/watch?v=RUgLUgw-O-U&feature=player_embedded

  5. Elliott February 5, 2012 at 5:00 am #

    oh and just for fun http://mises.org/daily/5747

    http://www.youtube.com/watch?v=qQg2-QBfOo0

  6. Central Bank News February 25, 2012 at 10:00 pm #

    This is why being a good economist or strategist is hard; and why it is an art and a science. You need to use hard data, you need to make use of models and theory, but you also need to be a acutely aware of what is going on; but from the perspective that economics is a social science. So while you need to build a good foundation of facts, data, graphs, models, etc… you need to chuck in a good heaping of critical thinking and creative thinking… the fuzzy/judgement part of it is where average economists/strategists become good or great; it’s not enough to find causality between one index and another metric, you need to be able to think about why the relation might exist, and what conditions might promote it or cause it to breakdown. Hard stuff, but fun stuff!

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