Economics Is Predictive … Sometimes
By Staff News & Analysis - January 02, 2015

So high expectations, so few riders … Criticizing economics for not being scientific enough is a crime of which many of us – I've done it – are guilty. But there's a right way to do it and a wrong way to do it. Alex Rosenberg and Tyler Curtain, writing in the New York Times, have done it the wrong way. – Bloomberg

Dominant Social Theme: Economics is a great tool for government and industry.

Free-Market Analysis: Noah Smith has written another article about whether economics is a science or not, a subject that obsesses him for good reason.

If economics is not predictive, what good is it in this day and age? In fact, the field is really only a few hundred years old, if we date it to Adam Smith's Wealth of Nations.

Smith explained "capitalism" in his great book, but in doing so he initiated a predictive approach. That's because he showed what kinds of industrial organizations worked and what kind didn't.

For Smith, as for today, the Invisible Hand organized commerce via competition. This is certainly a kind of scientific deduction. Of course, the "Austrians" came along and further refined the field with the concept of marginal utility. It is marginal utility that shows prices are developed by market forces not by governmental fiat.

As a result, when governments try to fix prices, the results are never what is expected. Price fixing inevitably ends in a queue, scarcity or both.

Mr. Smith doesn't mention price fixing in this article because it is basically a critique of a statement by the authors of the article. He quotes them as follows:

Over time, the question of why economics has not (yet) qualified as a science has become an obsession among theorists, including philosophers of science like us…The trouble with economics is that it lacks the most important of science's characteristics — a record of improvement in predictive range and accuracy…In fact, when it comes to economic theory's track record, there isn't much predictive success to speak of at all.

Smith himself rebuts this perspective:

Economics doesn't have predictive success, eh? This is something a lot of people claim, but once you look beyond the well-publicized fact that economists can't predict recessions, you can see that the claim just isn't true. Economics can predict plenty of things.

My favorite example is the story of Daniel McFadden and the BART. In 1972, San Francisco introduced a new train: the Bay Area Rapid Transit (BART). The authorities predicted that 15 percent of area commuters would use the system. But, using money from a grant provided by the National Science Foundation, University of California, Berkeley, economist McFadden and his team of researchers predicted that usage would be only 6.3 percent.

The actual number? 6.2 percent.

Now call me crazy, but I call that a predictive success. The models McFadden et al. used to make the prediction were clever extensions of simple utility theory — the oldest trick in the economic playbook. Those models, called "random-utility discrete choice models," have been applied in a huge number of areas, including product development, pricing decisions, marketing, energy usage and environmental-impact studies. In 2000, McFadden won a Nobel Prize for his efforts.

He provides other predictive examples as well based on auction theory and "gravity models."

Want yet another example? So-called "gravity models" of international trade, do a very good job of predicting how much trade will occur between any two countries, given the size of their economies and the distance between them. In other words, Rosenberg and Curtain are just plain wrong. Economics theory has plenty of predictive successes.

Smith claims that the reason people don't understand the success of economic modeling has to do with the lack of publicity about economic forecasting. However, he does admit in the article that the one area where economics fails almost entirely is in the area of macroeconomics.

"In terms of predicting booms and busts, economics is still looking for its first big success. But if you think that predicting recessions is economists' only mission in life, think again."

But this last sentence is questionable, isn't it? Did gravity-model predictions about trade hold up after the 2008 financial crisis? We would tend to doubt it. Many businesses went bankrupt in 2009 and 2010, and many governments found themselves on the verge of bankruptcy as well.

It is easy enough to "predict" certain economic functionalities when times are good and revenue is consistent. But the trick is to make predictions that account for economic downturns and provide some sort of insight regarding economic slumps.

Additionally, when inputs are the kind that people would object to – for instance taxes or additional regulation – then it is more difficult to make predictions as people are apt to take considerable "human action" to avoid the new demands. This is why taxes and regulations so often fail to achieve their goals and in fact tend to encourage opposite results.

We can see that Smith's contention that modern, Keynesian-style economics are predictive is questionable and econometric-based predictions often work only in the narrowest of circumstances.

Additionally, while Smith doesn't mention it and has been derisive about it, only Austrian economics provides us with a significant economic model that explains the modern, Western, boom-bust business cycle.

The Austrian business-cycle theory developed by Ludwig von Mises and FA Hayek puts the blame for exaggerated business cycles directly on central bankers who don't know – and can't know – how much money circulating in the economy is enough and how much is too much.

Central bankers use backwards-looking data to predict forward-looking economic permutations – and this is never a functional recipe. And by keeping rates at the zero-bound – in an almost compulsive fashion – central bankers aggravate asset bubbles and guarantee further economic implosions.

Predicting the performance of certain businesses in good times is certainly an example of how modern economics can be applied successfully, if narrowly. But since many economists have no larger model to work with, such predictions are bound to fail in the longer term. Economists would be closer to the mark if they recognized Austrian business-cycle theory, which has proven itself correct over the past century.

But to do so, the current crop of "court" economists would have to grant the reality of central-bank inspired economic disasters. And logically speaking, this would then lead to demands to diminish or end the modern monopoly fiat, central banking system.

It is easier for most economists and columnists to defend the current system than to criticize it. But this doesn't mean the current system is worth defending or saving.

Currently, central-bank money printing is leading to sizeable bubbles in different asset classes. Eventually, the current securities mania will deflate, leaving considerable ruin behind. This is because protagonists of the current system outnumber critics considerably.

It is only in the alternative media that one can find individuals presenting a different paradigm that predicts the kind of boom/bust cycle that central banks are adept at continuing. It is in the alternative media as well that you will find potential solutions to the next crisis, which may be the deepest one yet.

After Thoughts

People ought to examine alternative solutions to today's crisis-driven monetary system.

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