Do Economists Have a Crystal Ball?

It’s not uncommon to see a host of economists offer their predictions concerning economic conditions for the new year. This recent MSNBC article is a case in point. Unfortunately for those who rely on these forecasts, it turns out that they are less reliable than the weatherman. These faulty forecasts are a result of a misunderstanding of the methodology of economics, and perhaps even of what economics really studies.

The “science” of economic forecasting is an unfortunate by-product of the 1930’s Keynesian Revolution. In their attempt to scientifically steer the economy towards the ideal of “full employment,” government economists began collecting data on every economic variable conceivable. And as a professor of mine likes to say, “if you torture the data long enough, it will confess.” This pithy statement gets to the root difficulty with economic forecasting.

Why is the weatherman likely to be more successful than the professional economist when it comes to forecasting future events? Precisely because the weatherman is working with variables that can be held constant! There are still problems for the weatherman: he cannot account for every variable, and it is impossible to get an entirely accurate measurement of every variable. Nonetheless, he can hold some variables constant in order to determine what the effect of some other variable will be on his weather-model. This is exactly what economists cannot do. The proper study of economics is human action–something that is unpredictable and volitional. It is impossible to predict meaningfully about the future by examining aggregate data such as “unemployment,” “spending,” or “saving” without at least acknowledging that all these phenomena arise from individual human beings applying scarce means to achieve their subjectively valued ends.

The point is this: it is impossible to hold variables constant because the variables are comprised of human choices which no expert/economist can discern, let alone hold constant. A key insight of Austrian economists is that the future is uncertain, and human beings must deal with this certainty to the best of their ability by applying means to achieve their ends.

Another related problem with social science prediction is that it has no choice but to extrapolate trends from the past into the future. This method, however, is fundamentally flawed. Economics does not deal with static particles, but human beings that react to changes in their environment in an economizing way. One well-known example is the oil supply. “Experts” began predicting that we would run out of oil shortly after it was brought into productive use in the 1800’s. This has not happened because as oil becomes more scarce, the price increases, which makes it profitable to extract oil from deeper and deeper in the earth. In short, the price mechanism sends information to individuals who then begin a long process of adjusting their behavior, and this adjustment process is impossible to predict!

Lastly, there is one more fatal, and oft-overlooked flaw, of the economist-turned-psychic. If these economists were actually able to successfully predict future conditions, they would not be economists at all. They would be entrepreneurs. The entrepreneur is the who one who reaps a profit in reward for correctly forecasting future market conditions. If economists could predict the future as well as their economic models suggest, they would be able to reap massive profits. Why aren’t they doing so…?

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One Response to Do Economists Have a Crystal Ball?

  1. krlatham December 30, 2011 at 12:09 am #

    Good stuff. The proper method of economics is the utilization of thought experiments, where human decisions can be arbitrarily be held constant. Compare that holding human choices constant in an attempt to solve mathematical equation.

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