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Economics' limits

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Wednesday, Oct. 27, 2010

Economics is a science -- if "science" means a systematic, rational, open-minded and evidence-based search for understanding. Economics is not a science if "science" means a discipline that can make nuanced and specific predictions about the future.

The economy is far too complex to permit such predictions. Astronomers can accurately predict a solar eclipse because they have only a handful of objects to understand: the sun, the Earth and its orbit, and the moon and its orbit. In contrast, when we economists are asked, say, to predict the price of gold a year from today, we'd have to understand countless objects -- such as how the Federal Reserve, the European Central Bank and other monetary authorities will change the supply of money, the prospects of new gold discoveries and the likelihood of discoveries of new uses for gold.

We'd even have to divine those famous "animal spirits" that John Maynard Keynes accused of causing such economic havoc.

Keynesians make much too much of the fact that people's levels of optimism or pessimism about the future can change spontaneously. Nevertheless, it's undoubtedly true that investors' and consumers' and entrepreneurs' expectations about what each other will do -- and about what voters and government will do -- are not determined by a fixed mathematical formula.

So the best that economists can achieve -- and the most that sensible economists try to achieve -- is to make "if-then" predictions. If the Fed increases the money supply and nothing else changes, then we'll experience inflation. If tariffs are lowered and nothing else changes, then the economy will grow faster.

The trouble, of course, is that when dealing with a phenomenon like the economy with billions of moving parts, seldom does "nothing else change." It is this inability to know what will and what won't change that makes specific economic predictions notoriously unreliable.

If, say, voters in a few months unexpectedly put into office a socialist government, that fact will spark justified fear among investors and entrepreneurs (and many consumers) about the economy's future. The price of gold will unexpectedly rise above the level it would have achieved had voters not sprung this surprise on the economy.

What's true for the price of gold is true for the economy as a whole. Economic activity in the 21st century is the combination of the decisions of literally billions of people across the globe, many of whom are working hard to innovate -- to create new products and technologies that are today unknown. And all of these people have their own unique sensibilities regarding risks and uncertainties.

Economists can legitimately be criticized for committing an encyclopedia of sins, but failure to predict the exact timing and dimensions of an economic downturn -- including the one we're in now -- is not among those sins.

Ironically, however, one genuine sin committed by too many economists is the sin of public hubris -- of posing as seers who can divine the details of the future economy, of fooling themselves and the public that economists possess greater knowledge than they really do.

In their papers and books (and now blogs), Keynesian economists model the economy with simple symbols, such as "C" for consumption spending, "I" for investment spending and "k" for the economy's stock of capital goods such as diesel engines, steel mills and industrial chemicals.

Governments and private researchers gather data on consumer spending, on investment spending and on the market value of all the stuff called "k." Economists plug these data into computer-based mathematical models filled with "C's" and "I's" and "k's" and other symbols from alphabets both Latin and Greek. These models then spit out precise predictions.

Voila! exclaims the economist slathered in hubris. "See my multivariable model and my precise-to-several-decimal places predictions! I'm a scientist!"

In fact, he's an alchemist. He is misled -- by the intricacy of the equations on his computer screen and by the apparent concreteness of the data that he shoves into those equations -- into thinking that he's doing science. He is misled into thinking that these leaden, aggregated data from the past can be transformed into golden truths about the future.

But they cannot be so transformed. Most of what is relevant in the economy occurs within each "C" and "I" and "k." Say that consumers switch from buying beef to chicken. If the total amount that consumers spend remains unchanged, then "C" remains unchanged, yet genius-boy economist misses this change because he thinks that all that matters regarding consumption is the total value of "C."

Likewise with the other variables.

Talking about the economy as if it involves the interplay chiefly of large aggregates such as "consumption" and "investment" blinds Keynesian economists to the real action that takes place at a much more detailed level. It's a very unscientific approach.

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