Should economists be “imagineers” of our future?
By Mark Thoma The opinions expressed are his own.
This essay is a response to Roger Martin’s “The limits of the scientific method in economics and the world” (part one and part two), recently published on Retuers.com.
Roger Martin is unhappy with the state of economics. One charge is that:
[an economist] predicts a future that is based on the past. And when it is anything but, he returns to the same tools to do it again, believing that in doing so he is being meritoriously scientific. … Extrapolating the future to be a straight-line projection of the past is neither accurate, nor is it helpful in creating better understanding and newer ideas.
As I will discuss further below, I agree that macroeconomists need to fix their models. But I don’t think that predicting the future based upon “a straight-line projection of the past” is the problem. Let me explain why, first in a relatively narrow sense, and then more broadly.
This year’s Nobel prize award to Thomas Sargent and the previous award to Robert Lucas were partly in recognition of their development of the tools and techniques that economists need to go beyond simply trying to extrapolate the future from the past, a procedure that can lead forecasters astray.
Prior to Robert Lucas, economists analyzing policy interventions by monetary or fiscal authorities did exactly as charged above, they extrapolated based upon the past and an assumed unchanging future. But the (often false) assumption that the future would be like the past is at the heart of what is known as the Lucas critique.
The limits of the scientific method in economics and the world
By Roger Martin The opinions expressed are his own.
Part one of this essay was published Thursday. This is part two.
As the power of the scientific method has encroached further than its applicability warrants into fields such as economics and business, its predictions of the future become ever more erroneous. In this list, we can include virtually every economic prognostication from the first half of 2008, and countless market research studies that misjudge consumer interest in the new product concepts that they test.
Were he alive today, Charles Sanders Peirce, a turn-of-the-20th-century American pragmatist philosopher, would be unsurprised at the shoddy results of these analyses. A brilliant thinker, Peirce is less famous than his peers William James and John Dewey, mainly because he was an ornery and unpleasant character. However, Peirce had an almost entirely overlooked yet extremely insightful theory applicable to modern scientific work. He concluded that no new idea was ever derived from the analysis of the past using inductive and deductive logic – the two forms of logic our modern scientific method utilize.
These forms of logic can only prove things in the past, so whether business people, economists and scientists realize it or not, the only thing about the future that the application of deductive or inductive logical analysis can predict is a simple extrapolation of the past. That is very useful for studies of things in the Aristotelian camp of cannot be other than they are. If we find some property of granite by studying existing hunks of granite, we can safely extrapolate that in the future, hunks of granite will have those properties.
However, deductive and inductive logical analyses aren’t so hot for things that can be other than they are – like economy for example. These things change constantly due to the interactions of the people and organizations. The fall of 2008 wasn’t an extrapolation of the past – it was discontinuous with the past.
If economists were being Peircian, when they saw an anomalous situation of the unprecedented economic meltdown of fall 2008, they would have taken all of our disparate knowledge and mingled it together creatively to ask: what on earth could be going on here? Rather than forgetting entirely that their theories were demonstrated to be totally lacking, and then going on to analyze some more and predict more based on those theories, they would have created a new hypothesis to explain what just happened. This would be what Peirce evocatively called ‘a logical leap of the mind’ and ‘an inference to the best explanation.’
Physics doesn’t apply to the demand side because economists can ignore the depreciation of automobiles owned by consumers but the depreciation of identical cars owned by Hertz and Avis do depreciate.
So in economics the Laws of Physics are affected by semantics. So the depreciation of hundreds of millions of cars around the world do not affect the Net Domestic Product of any country.
http://www.spectacle.org/1199/wargame.ht ml
The limits of the scientific method in economics and the world
By Roger Martin The opinions expressed are his own.
This is part one of this essay. Read part two here.
As the economy teeters and the capital markets gyrate, I can’t get out of my mind the evening of May 19, 2009. We were near the stock market nadir and fears were cresting that we were heading straight into the next Great Depression. I was invited to a dinner along with half a dozen tables of guests to hear a very prominent macroeconomist opine on the state of the economy and the path to recovery.
The economist held forth with a detailed, analytical account of what had caused the economic meltdown in the second half of 2008 and the path that he predicted recovery would take. I was struck by how scientific he was, spewing myriad statistics, employing technical terms by the boatload, and praising his econometric model. It was ‘very sophisticated’. Given the nods and encouraged looks in the room, it seemed as though he had provided great comfort to the guests; they could go to bed confident that thanks to his science, they could trust that this man knew where we were headed.
I wasn’t quite so confident. Being the curious sort, before coming to dinner I had checked his forecast from a year earlier, mere months before the crash. His spring 2008 forecast for the second half of 2008 was for modest positive economic growth for America. This was not unusual; no credible economist predicted anything less rosy for the back half of 2008, although many now claim that they did. I don’t blame or ridicule him for being cautiously optimistic mere months before the worst economic downturn in 80 years. Economic forecasting is fraught with peril.
For me, the striking thing about the evening was that nothing changed about his models after they were shown to be hopelessly wide of the mark. He just loaded up the equations, dumped in the latest numbers and started crunching away. I asked him whether he had altered his models in the wake of his dreadful forecast of 2008; stunningly, he hadn’t thought of the question.
It struck me then and still does that this dinner is illustrative of a fundamental blind spot in modern science. It has ventured far afield of its natural limits and is both creating problems and inhibiting progress.
Yes, but…aren’t you just saying Science is a progression by which human knowledge is built up over time ?
Blaise Pascal in 1635 noted that Man is full of hubris : the world is not what it is. It’s what we know it to be. As our knowledge grows, it changes.
Thomas Kuhn said the logic of scientific revolutions is always a paradigm shift – rejecting the previous paradigm to move forward.
Nicholas Talleb said : until we know differently, the future will always be seen as an incrementally larger version of past trends. But this is wrong. Change happens through big non-incremental shocks to the system.
If Pascal, Kuhn and Talleb are correct, your economist is simply following in very good well-worn footsteps ?
On the other hand, when in 2004-05 we saw housing prices across the USA rising at 15-20% p.a., but disposable incomes only rising at 3% p.a., surely we should have suspected a bubble ?
from The Great Debate UK:
Banks get mixed reviews from institutional shareholders
- Brendan Wood is Chairman of Brendan Wood International, a global intelligence advisory firm. Recently, BWI published the World’s TopGun CEOs as ranked by 2500 institutional investors, which provides insight into the executives in whom shareholders feel the greatest confidence. The opinions expressed are his own. -
Brendan Wood International tracks the competitive position of investment bankers in global and regional markets. It also compiles the confidence rankings of hundreds of global shareholders in corporate investments, including those in the world’s leading banks. As of mid-2009, the Brendan Wood Investor Panel found a mixture of sharp criticism, but also some occasional strong praise for these “newly refurbished” financial behemoths.
First, the bad news: while all the banks have by now somewhat improved their situation from what it was earlier in the year – repaying $68 billion in government assistance, raising new equity, and carrying out a number of boardroom shuffles – their improving news and modest profit reports have not led to any total absolution from the Brendan Wood Panel for the worst falls from grace when the credit crisis exploded.
Citigroup still draws some harsh judgements, and not just for the hangover consequences of the Sandy Weill and Chuck Prince eras, but for its more recent direction by present CEO, Vikram Pandit.
Responses from the Brendan Wood Panel were taken before Pandit’s recent new top management shuffle (Edward “Ned” Kelly previous CFO is now Strategy and M&A leader becoming Vice-Chairman, John Gerspach, previous controller and Chief Accounting Officer is now CFO, and ex Merrill Lynch Vice Chairman Eugene McQuade is now CEO of Citibank NA, not to mention the stepping down of Chairman and CEO Bill Rhodes), but it appeared unlikely that any such changes would be greeted with great enthusiasm from shareholders.
The unhappiness of Bank of America shareholders with the costs and immediate consequences of the Merrill acquisition are now a matter of public record. It showed up in the shareholder commentary from the Brendan Wood Panel, but there was also recognition that the Bank actually did very well on investment banking performance rankings, leaping up to the same kind of level as JP Morgan Chase in the second quarter.
Again in the case of Citigroup, some shareholders expressed discontent that went beyond the specific issue of the expensive Merrill acquisition, fearing ‘a disharmonious culture’. But there was also recognition from shareholders that the large Merrill distribution network can still be a gradual source of increasing strength.
I usually don’t listen to economists for financial information. I go with my outsourced cfo services for information on my industry. Every industry is effected differently in a downturn.