Economists and the Future; L. K. Reed

And yet, he employed one of the most sophisticated mathematical models money can buy. What does an economist do, hav ing erred so grievously? Quietly re treat into the shadows of academe? Not at all! Undaunted, he will wipe the egg from his face, resume his place in the crowded fraternity of economic soothsayers, and begin work on next year's prediction for Gross National Product-to the nearest tenth of a per cent. In the welter of fallacious forecasts, hardly a soul will single him out anyway. The dismal record of the forecast ing profession led one economics professor at the State University of New York to conclude recently that Mr. Reed is Chairman of the Department of Econom ics at Northwood Institute in Midland, Michigan, and Director of the college's annual Freedom Seminars.

ECONOMISTS AND THE FUTURE 303 non-economists on balance are bet ter at seeing the future than are the professional forecasters. Perhaps it is time for the professional sooth sayers to re-examine their premises and methods. What is it about the future that makes it so hard to describe? The answer is at once both simple and profound: it hasn't happened yet! Human hindsight is often "20-20" but it is beyond human mental lim its to really know with much preci sion what tomorrow will bring. No palm reader, no fortune teller, no astrologer, no forecaster, not even an econometrician, can ever dispel the uncertainty of the future. Austrian economist Ludwig von Mises, inHu man Action, tells us: If it were possible to calculate the fu ture state of the market, the future would not be uncertain. There would be neither entrepreneurial loss nor profit. What people expect from the economists is be yond the power of any mortal man. 1 So it is that the existence of un certainty is a commentary on the nature of the human condition it self. It is what Murray Rothbard terms "a fundamental implication derived from the existence of human action." In his monumental work, Man, Economy, and State, Rothbard expounds: This must be true because the con trary would completely negate the pos sibility of action. If man knew future events completely, he would never act, since no act of his could change the situ ation. Thus, the fact of action signifies that the future is uncertain to the actors.

This uncertainty about future events stems from two basic sources: the unpre dictability of human acts of choice and insufficient knowledge about natural phenomena. Man does not know enough about natural phenomena to predict all their future developments, and he can not know the content of future human choices. All human choices are contin ually changing as a result of changing valuations and changing ideas about the most appropriate means of arriving at ends. This does not mean, of course, that people do not try their best to estimate future developments. Indeed, any actor, when employing means, estimates that he will thus arrive at his desired goal. But he never has certain knowledge of the future. All his actions are of neces sity speculations based on his judgment of the course of future events. The om nipresence of uncertainty introduces the ever-present possibility of error in hu man action. The actor may find, after he has completed his action, that the means have been inappropriate to the attain ment of his end. 2 (emphasis Rothbard's) There Is a Need to JUdge What the FutureMay Bring To say that the future is uncer tain, however, does not mean the end of the matter. Surely, entrepreneurs who assemble the tools of production today, as Rothbard points out, must make decisions based upon what they think the future will hold. They make 304 THE FREEMAN May it their business to grapple with questions such as: What will the general state of business be next year? How much will materials cost and will they be available? What wage rate will be required to attract and keep the kind of employees we need? What will be the effect on sales if we change our prices? What are our competitors likely to do? Where will the best markets for our prod ucts be? Is this a good time to seek outside financing or will interest rates decline in coming months?

Should we be working down our in ventories? What will the politicians do that might affect our business? Consumers, securities investors, government policymakers, and, of course, economics professors on the lecture circuit, join businessmen in the search for information about the future. The real question is, what can we reasonably say about tomorrow and what methods enable us to say it? A review of the more prominent methods of economic forecasting is now in order. A. Simple Trend Projection This approach relies upon pure extrapolation of previous trends in some economic activity and as such offers little more than a pretense to being scientific. It works only inso far as current trends continue. It does not begin to account for, let alone incorporate, any significant changes or turning points. Professor James B. Ramsey terms it "naive predic tion" and offers this critique: Either the predictor estimates some relationship and assumes that the same results will hold in the future; or he pre dicts values by using currently observed trends in economic variables over time, for example, he says next year's income will be equal to this year's plus 5 per cent. There is no attempt to provide a theoretical model in order to understand the observed relationships.· There is no concern for identification and little for separating out the individual effects of exogenous variables. 3 Thomas Malthus, early in the nineteenth century, used a kind of simple trend projection to forecast starvation and over-population. More recently, the so-called "Club of Rome"

relied on the same approach to pre dict the same thing. In Malthus' case, the Industrial Revolution interfered with his projection rather deci sively. The Club of Rome's pro jection did not foresee the decline of birth rates in industrialized countries. To the extent that forecasters em ploy simple trend projection (and many of them do), they are walking on ice so thin you can hear it crack ing as they go. B. Gross National Product Models The concept of GNP purports to express the total value of all goods and services produced during a given period of time. It is the consumma1983 ECONOMISTS AND THE FUTURE 305 tion of "national income account ing" -the process of identifying and adding up all the components which comprise the economy. Basically, GNP is "determined" either by (a) summing the total ex penditures on the "final product" goods and services produced during a period or (b) summing the total cost incurred as a result of producing the goods and services applied during the period. 4 GNP is probably the most widely used "measure" of total economic ac tivity and is the statistic which most conventional analysts use to express their predictions of business perfor mance. Its many components sup posedly. comprise a "model" of the economy which can be a foundation for economic forecasting.

What on the surface appears to be massively profound turns out to be something much less. GNP, being the most "aggregate" of statistical ag gregates, is riddled with problems and errors and, what's worse, prob lems and errors of unknown magnitude. Those problems and errors stem from both the complexities of statis tical measurement and the difficul ties of basic conception (what to in clude). What follows is an accounting of just a few. 1. Errors of estimation. Simon Kuznets himself, the "father" of GNP, suggested once that assuming an average margin of error for national income estimates (a prime compo nent of GNP) of about 10 per cent would be reasonable! Yet, some economists routinely predict quar terly GNP figures in tenths of one per cent. Congress often makes pub lic policy based upon those compu tations which, even if accurate, con jure up what Roger Garrison describes as "the vision of a dieti cian who weighs a locomotive both before and after the crew boards it, then uses the difference between the two weighings as the basis for pre scribing a diet for the whole crew."5 2. Incentives for collectors of the data to fabricate or twist the sta tistics for personal or political advantage. We know that economic statisticians in communist and Third World countries are notorious for this. Is it really unreasonable to as sume that some twists or fabrica tions happen here too? In a recent, rather blatant example, the govern ment decided to quietly start count ing the 1.7 million members of the armed forces in this country as part of the work force for the first time.

That at least will make the official unemployment figures look better for those in public office. 3. Incentives for individuals pro viding the statistics to report in correct figures. Such distortions occur as individuals attempt to guard 306 THE FREEMAN May trade secrets, evade taxes, or mis lead competitors. 4. No account is made for the ac tivities of the "subterranean economy." Giving Caesar the slip has become common practice as Americans are called upon to dig deeper in their pockets for what Caesar claims is his. Underground transactions, which totally escape the tax and data collectors, probably amount to hundreds of billions of dollars and probably are rising. 5. Things not exchanged for dol lars are not included. Paint your own house and the value of the work performed is not calculated by the statisticians; hire a painter and his wages become a part of GNP. Like wise, if a man divorces his wife and then hires her as a cook for $100 a week, GNP will increase by $5200 annually.

6. Government spending raises GNP. When government spends more, it diverts funds away from more efficient allocation by the mar ket. One economist suggested-with some sincerity-that it might be more in line with reality if govern ment expenditures were subtracted from GNP! 7. Inappropriate depreciation al lowances. These are determined by often unrealistic assumptions underlying the tax laws. Inflation in recent years, for instance, has ren dered depreciation allowances quite inadequate. 8. Changing quality of goods not reflected. GNP would not rise if an improvement in a product did not result in a higher price. 9. Exclusion of leisure. Leisure is very much an economic good (sub jectively valued and incapable of quantification) and people often opt to "consume" more of it and to con sume less of the more "traditional" goods and services. 10. Frequent revIsIons. This shortcoming is related to the first one cited above. GNP statistics are con stantly subject to revision. Those adjustments are often significant and sometimes come months or years af ter the initial calculation. In short, by the time we have a statistic which we can reasonably assume is "final,"

it may have long since lost any fore casting value, if indeed it had any in the first place. Reliance on Gross National Prod uct models as tools for accurate fore casting has repeatedly led econo mists astray. It seems that, at best, such models say something about the past, and nothing about the future. Professor Kenneth Boulding's refer ence to GNP as "one of the great in ventions of the twentieth century, 1983 ECONOMISTS AND THE FUTURE 307 probably almost as significant as the automobile,"6 goes down as a gro tesque exaggeration. C. Econometrics Many of the problems of simple trend projection and GNP models are present in the more sophisticated, heavily quantitative, econometric models. These constructs, which many once thought to be quite promising, often comprise hundreds of mathematical equations that pur port to represent relationships among the major aspects of economic activ ity. Expensive, high-speed comput ers churn out the meticulous fore casts of the econometrician.

The record of these models has been dismal indeed. Mistakes in econometric forecasts have often been so bad that merely changing their signs from positive to negative or negative to positive would have put them significantly closer to the mark. Business Week for March 30, 1981 provides a case in point: The big econometric models began sig nalling a downturn early in 1979 and construed the second-quarter dip as the' onset of a potentially serious recession. After the third-quarter recovery, they kept betting that the next quarter would turn negative. Then, when last spring's drop was already under way, they turned briefly optimistic until the worsening statistics convinced them that their ini tial pessimism had been correct. They were wrong once again, because the economy picked up during the summer and was still running strong at the end of the year. "They were not only consis tently wrong, they constantly changed their forecasts in the wrong direction,"

notes Stephen K. McNees, an economist at the Federal Reserve Bank of Boston whom the econometricians themselves rely on as an arbiter. 7 These errors certainly do not oc cur because the practitioners of this method do not try. They are simply employing inappropriate assump tions-assumptions that if rejected would lead to the virtual termina tion of econometric models as we know them. Economics as a science is best an alyzed qualitatively, not quantita tively. There are no truly constant relationships in human action, which means that most of the relationships postulated in the equations of econ ometric models are invalid. "Gar bage in, garbage out," as they say in computerese. Economists have acknowledged for decades that the function of the en trepreneur is to anticipate changes in the marketplace. Once the entre preneur has made a decision, he then exposes his wealth and income by arranging factors of production in such manner that he may satisfy fu ture consumer demand. If he antici pates correctly, he will earn entre preneurial profits; if his judgments are wrong he will incur losses. Any number of variable and unforeseen elements may arise to affect the out308 THE FREEMAN May come: changes in fashion and tech nology, government policy, labor union activities, competition, prices, and even the weather. None of these elements is entirely predictable; none can be accurately determined by past performance. Attempts to mathe matically estimate these elements in advance or to attach numerical sig nificance to the subjective judg ments of the entrepreneurs them selves are pure folly. They are doomed to suffer the failure which lies in gross simplici ty and imprecision.

Not a Precise Measure It is ironic that econometrics strives for the exactness of numbers and yet bogs down in static equa tions which necessarily cannot be gin to account for all the relevant factors and their interrelationships. Economist Henry Hazlitt tells us that if a mathematical equation is not precise, it is worse than worthless; it is a fraud: It gives our results a merely spurious precision. It gives an illusion of knowl edge in place of the candid confession of ignorance, vagueness, or uncertainty which is the beginning ofwisdom. 8 Perhaps Mises said it best when he wrote: The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuation and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. 9 (emphasis mine) The equations of econometric models profess complexity, yet they really represent a feeble, simplistic, and futile effort to mirror the infi nitely more complex network of hu man actions we call "the economy."

They fail to account for many un foreseen economic variables and make little effort to recognize the interaction between economic and noneconomic variables. Their static, impersonal, and aggregative ap proach leaves acting man out of the picture, replaced by lifeless equa tions of often dubious value. The one way they could be reliably predic tive would be if people ceased changing and became robots; then the econometrician could "get a handle" on them. One observer recently commented that to predict economic events, one must first predict political events. Unfortunately, there is much truth in that statement. Today, it is not enough to consider endogenous mar ket forces when contemplating the future. One must reckon with the exogenous influence on the market of colossal, erratic government. Pol iticians and their bureaucratic foot soldiers throw their weight around like bulls in a china shop. Predicting 1983 ECONOMISTS AND THE FUTURE 309 the outcomes of the political process is like trying to forecast which vases the witless bulls will break next.

Econometric models are incapable of foreseeing such events. The failure of econometric fore casting should come as no surprise. But it would be surprising were its practitioners to admit failure. D. Statistical Indicators This approach utilizes measure ments of economic activity which supposedly "lead," "coincide with," or "lag" the business cycle. A list of leading indicators gener ally includes the money supply, housing permits, stock prices, raw materials prices, inventories, and corporate profits. Roughly coincident indicators in clude industrial production, factory capacity, retail sales, and personal income. Unemployment, bank rates on short-term business loans, labor cost per unit of output in manufacturing, and new capital appropriations are considered key lagging indicators. Obviously, the group which is supposed to have the most predic tive value is the group of leading in dicators. The Commerce Depart ment compiles the monthly "Composite Index of Leading Indi cators," a widely followed statistic.

Just how reliable is it? The index's lead time in signal ling the onset of recessions has ranged from four months to nearly two years, which makes it a shaky guide for anyone trying to plan for economic swings. The index's performance in call ing the upturns is only marginally better. On several occasions, it has signalled booms or busts which never materialized. Statistical indicators, regardless of their category, often have substan tial inherent weaknesses. Many of those weaknesses are akin to those described above with regard to GNP, itself viewed as "roughly coincident" to the business cycle. The Producer Price Index, for in stance, measures changes in charges by firms that make goods. It is based largely on returns from sellers, who tend to report list prices. Not recorded are the many trades that take place at discounts or at premiums. The Consumer Price Index is the most-watched "cost of living" figure.

It assumes that families buy items in the same proportions as they did in the base year of 1972-73, even though changes in lifestyles have since taken place. For one thing, it seems that an increasing number of Americans today are keeping their cars longer than they did ten years ago, so the purchase of a new car carries much less weight in a fami ly's budget. Also, the CPI vastly overweights average housing costs and does not take into account the fact that peo310 THE FREEMAN May pIe tend to buy more of a substitute when the price rises on their first choice. They buy more chicken, for example, when beef prices go up. Official figures on unemployment are an important factor in govern ment planning. But the figures, based on household surveys, are deceiving. For example, some able-bodied peo ple cannot get certain types of wel fare unless they are actually looking for work, so they may facetiously tell survey takers that they are job hunting. They then become offi cially unemployed.

Assuming it possible to assemble accurate statistics which indicate what they are supposed to and do not require later revision, we might have a sketchy picture of where "the economy" was or perhaps where it presently is. But we still couldn't say for certain, based on the figures, where it is heading. Educated Speculation Having said all that, it nonethe less stands to reason that if we are to be able to say anything at all about the economic future, we probably should know something about the economic present and past. That's where reliable statistics might play some part, not as a basis for simple trend projection, but merely as de scriptions of economic activity al ready behind us or underway. Even the finest and most accurate statis tics, though, should only be ingredients in a more fundamental ap proach now to be examined. For want of a more descriptive title, I shall call it Educated Speculation.

This approach is characterized by the following: 1. A clear recognition of the un certainty of the future with no "leaps of logic" or mindless extrapolations. 2. Careful use of only the most meaningful statistics, understand ing all of the limitations of such ag gregates discussed above. This im plies a task of "de-aggregating" aggregates-of analyzing economic acti vity as it results from acting, de cision -making, welfare-maximizing individuals. 3. A sound understanding of basic economic principles and of the polit ical process. 4. A thorough grasp of the causes and consequences of the business cycle. With these tools, an economist can proceed to say something about the future and have some reasonable grounds for saying it. He still must be wary, though, of how far he can go. Brian McAndrew, writing in the Cato Institute's Policy Report for November 1981, clarifies this point: If forecasters recognized the limi ta tions of economic theory and empirical information, they would realize that the most an economist can hope to do is ex plain the likely consequences of different policies. An economist can show, for in stance, that a minimum wage tends to 1983 ECONOMISTS AND THE FUTURE 311 cause unemployment because it alters supply and demand conditions in the la bor market. An economist cannot say ex actly when, where, and by how much un employment will rise (Le., he cannot forecast the unemployment rate), but he can say that if a minimum wage law is instituted unemployment will tend to in crease. In addition, he can, by combinin§.

theory with empirical information, get a rough idea of the amount of unemploy ment caused by the minimum wage at different times in the past, but he cannot say what this amount will be in the future. 10 The Austrian Theory In this world of radical interven tionism, correct business cycle the ory is crucial to our ability to say anything about the future. Cycle theories abound, but the one which fully integrates an explanation of the cycle and its features with an anal ysis of the entire economic system is known in various circles as the "Austrian malinvestment theory." Propounded first by Ludwig von Mises and later enlarged by Nobel laureate Friedrich von Hayek, the Austrian theory holds that the source of the cycle lies in money and credit expansion orchestrated by central authoritip,s and proceeds to explain its effects. It is the theory which en abled Mises during the subtle infla tion of the 1920s to warn ofa coming depression. Few believed him until it happened. I direct the interested reader to more detailed accounts found in the works of Mises, Hayek, and Rothbard.

In the final analysis, the art of en trepreneurship is the art of "edu cated speculation." It is upon the shoulders of the entrepreneur in the market economy that the burden of "educated speculation" rests. For him, it is, in the words of Rothbard, "a matter of intuition, 'hunch,' and deep insight into the slice of the market that the entrepreneur knows and is dealing with."ll Entrepre neurship remains a vital, creative talent which economists would do well to spend more time examining. (See two works by Israel M. Kirzner: Competition and Entrepreneurship and Perception, Opportunity, and Profit.) "Educated speculation," as I have termed it, is really economics brought down to earth. It may not be as fancy as econometrics or GNP modeling, but neither is it as pretentious. It says simply that an economist should be an economist, not an aspiring prophet. The reader who began this essay hoping to discover a crystal ball may be disappointed that I have really offered nothing of the kind. Instead, what I have attempted to show is that much of what is commonly re ferred to today as "economic fore casting" goes far beyond the real abilities of economists to predict the future. Rothbard offers us this so bering reflection: 312 THE FREEMAN As Ludwig von Mises used to point out to those who were tempted to succumb to the razzle~dazzle of economic forecasting: If someone were really able to forecast the economic future, he wouldn't be wasting his time putting out market let ters or econometric models. He'd be busy making several trillion dollars forecast ing the stock and commodity markets.

Let it be a reminder to anyone tempted to partake of, or give credence to, this modern form of soothsaying. 12 @' -FOOTNOT~S1Ludwig von Mises, Human Action: A Trea tise on Economics (3rd revised ed.; Chicago: Henry Regnery Company, 1966), p. 871. 2Murray Rothbard, Man, Economy, and State (Los Angeles: Nash Publishing, 1970), pp. 5-6. National Income 3James B. Ramsey, Economic Forecasting Models or Markets?, Cato Paper No. 10 (San Francisco: Cato Institute, 1980), pp. 37-38. 4James D. Gwartney and Richard Stroup, Economics: Private and Public Choice (2nd ed.; New York: Academic Press, 1980), p. 116. 5See p. xii of Garrison's Foreword to National Income Statistics by Oskar Morgenstern, Cato Paper No. 15 (San Francisco: Cato Institute, 1979). 6Gwartney and Stroup, p. 128. 7"Where the Big Econometric Models Go Wrong," Business Week, March 30, 1981, p. 70. 8Henry Hazlitt, The Failure of the "New Eco nomics" (Princeton, N.J.: D. Van Nostrand Company, Inc., 1959), p. 99.

9Mises, p. 118. lOBrian McAndrew, "The Failure of Econo metric Forecasting," Policy Report, November 1981, p. 6. uSee p. xi of Rothbard's Foreword to Ram sey's Economic Forecasting. 12Ibid.,p. xii. IDEAS ON LIBERTY WE can raise our national income to any figure we want simply by depreciating the dollar enough to raise prices to reach that income. In Germany, in 1923, the national income (in marks) actually rose to hundreds of billions of times higher than its previous level, because the paper mark was depreciated to one-trillionth of its former purchasing power. To be sure, when explicitly taxed with the point, economic planners will say that their goal is a national income of x billions "in dollars of present purchasing power." But they forget this qualification in actual practice. They are always citing the latest national income figures in terms of the latest and most inflated dollar. They do not stop to remind us, or even themselves, how much the national income would have to be written down to reflect the price level of, say, twenty years ago.

"The national income approach" has become one of the important incitements to inflation. For the easiest and surest way to get constantly bigger national income figures is not by increasing output and consumer satisfactions, but by constantly shrinking the measuring rod, by con stantly depreciating the dollar. HENRY HAZLITT, The Failure of the "New Economics"