In light of recent unprecedented events, it seems like economists can’t tell us anything about what will happen next. What do economists do when their theories suddenly see useless? Do they have to come up with a whole set of new ones?
A friend of mine posed that question the other night, and it is a good one. She is right: Economists cannot predict with any certainty how the U.S. economy will perform over the next 1 to 24 months.
What is wrong with economics if thousands of its best practitioners, working with sophisticated computer models and more data than anyone could have imagined a generation ago, cannot make reliable forecasts?
There are two possible answers. First, existing economic theory and analytical methods may be sound but limited in their capabilities. Second, the theories and analytical methods themselves may be erroneous and in need of overhaul.
Historically, one can find instances where either of these possibilities was true. Which is happening right now?
I think it is clearly the first, that much economic reasoning is sound, but we economists have to acknowledge that the predictive capabilities of our discipline still are very limited. But some will argue that it is the second.
Let’s look at a couple historical examples of when economics seemingly broke down. Prior to the Great Depression, most economists believed that market-based economies were basically self-regulating mechanisms. If an economy slowed down as part of the business cycle, the situation would automatically correct itself in a few quarters. If government interfered, it would only make things worse.
But when the world slid into recession after 1929, no such automatic return to equilibrium took place. Output and employment remained depressed, year after year.
John Maynard Keynes, a British economist, argued that existing theory was wrong. Automatic recoveries from recessions were not guaranteed. Governments could take actions to stimulate sluggish economies by cutting taxes, raising spending and having the central bank increase the money supply. If a different problem, inflation, raised its head, government could banish it by retarding economic activity through higher taxes, less spending and by constricting growth of the money supply.
Prewar arms spending, rather than conscious application of Keynesian prescriptions, ended the Depression, but there was a sea change within economics. Government “intervention” was no longer a bugaboo. For four decades, most economists believed that governments could and should try to manage output, prices and employment. The consensus was that prior theory had been wrong.
Keynesian theory assumed that governments might have to deal with either inflation or unemployment, but never both at the same time. Yet by the late 1970s, Western countries that had followed Keynes’ advice faced high and rising levels of both inflation and unemployment. A new term, “stagflation,” was coined.
Economic theory clearly was in error. “Rational expectations” economists showed how classic Keynesianism was wrong. Theories were revised.
Economists largely failed when they tried to predict the impacts of Pearl Harbor, peace after World War II or the Korean War and its ending. Few had any good sense of what would ensue after the first OPEC price rise in late 1973. And hardly anyone foresaw how strong the 1990s information technology boom would be.
These are all historical examples of exogenous shocks–political, technological or natural events outside of economic policy itself that dramatically changed the environment for economic decisions.
Economic theory could predict everyday decisions; people still bought more hamburger if it was on sale, and businesses still kept production lines running if revenue from making one more unit covered variable costs. But for a time, there was such uncertainty about the overall economic environment that it was impossible to make informed forecasts.
We are in such a period now. Existing economic theory is strong enough to tell us what is likely to happen on a limited scale. If a South American country increases its money supply rapidly, it will experience inflation. If U.S. farmers have a big corn crop, prices will be lower than if yields are low. A decrease in demand for gasoline will lower gas prices.
But economics cannot predict how consumers and businesses will react to new fears about vulnerability to sneak attacks or how expanded conflict in the Gulf region might affect energy costs. Nor can we tell how deep public fears about flying will be. This inability is not due to erroneous economic models, but to limited ones.
Perhaps in 2101 our forecasting capabilities will be greater. But for now, economists need to acknowledge the limitations of our discipline.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.