Richard Ebeling Takes A Step Too Far

By Robert Wenzel

In a comment to Peter Boettke, Richard Ebeling discusses the dangers of economic forecasting and of using statistical models to forecast the future.

He writes:

In fact, neither Austrian Economists nor our Neoclassical and Chicago and Rational Expectations "colleagues" know what is happening in the economy -- nor exactly how and why it hit right now or where the present "crisis" is taking us.

The problem with this comment is that it goes too far in denying what we can and can not know about about an economy.

He is correct when he next writes:

The "deadly sin" of hubris clearly has been greater with our economist colleagues. So using all available information (i.e., statistical patterns of past events) and inserting it in the "correct" model of how the macroeconomic "really" works . . .

Econometric models simply don't work in economics where all factors are variables and there are no constants. Indeed, part of the mortgage crisis, as I have written, was a result of the use of faulty econometric equations:

The problem consists in the fact that econometricians can't design equations without at least one constant. Since there are no constants in the world of human action, econometricians take a variable that has held fairly constant over some period of time and assume it is a constant. This works fine, and can for long periods of time, until Wenzel's Observation #1 comes into play: Any variable has the potential to eventually start to dance. A dancing variable is one that no longer acts like a constant and moves considerably outside its previous assumed range of movement.

In the case of the mortgage crisis, econometricians assumed a very narrow range of movement for default rates on sub-prime mortgages. What they failed to take into consideration was that in the new world of securitization, many originators of mortgages did not have incentive to carefully analyse the ability of a borrower to pay a mortgage, since the originators sold off the mortgages and simply earned an origination fee, without exposure to default risk. This resulted in originators creating mortgages with the potential for much higher default rates. Thus, the default rates on subprime mortgages started to dance in a dance style not scene since Michael Jackson's moonwalk dance.

Ebeling goes on:

...Austrians have long insisted that the laws of economics are essentially logical relationships, not empirical ones; that economics can "predict" but only in qualitative terms, not quantitative ones; that economics can only make "pattern" predictions.

Austrians (true to their theory of the logic of the interconnections between credit expansion, market rates of interest, the term structure of investment, and relative price and allocation effects caused by the non-neutrality of money) have often warned of the inflationary and destabilizing consequences from Fed policy over te last decade.

All this is very true. But then he writes:

...no Austrian could (or did) claim to know when the cycle would turn, or what would set it off, and how the downturn would or could play itself out, i.e., in what in historical retrospect we will see from the vantage point of some future moment as the actual patterns and also unique time-sequence of the "micro" steps by which this will play out.

...We know how the Great Depression of the 1930s played out because it is now history....But instead of reading histories of the Great Depression, suppose we went into the archives of the newspapers of the time -- the "Wall Street Journal," the "New York Times" -- and, say, from 1929 to 1935 read the stories, day-by-day, the analysis and the commentaries and interpretations of what was happening and where it was leading.

I would suggest that virtually no one knew where the process was leading. Because it depended upon the "complex phenomena" of individual decisions, political policy choices, ideological influences, and everyday actions based on the expectations held at each moment in time....We will know all the answers [about the current crisis]-- when some future economic historian (maybe even an "Austrian") writes the history of our times, and tries to tell those future readers how it all happened and why.

What Ebeling is doing here (Curiously, for an Austrian, in empirical fashion.) is pointing to the facts of the Great Depression and arguing that only in hindsight can we know what occurred, and that no correct forecasts can be made in real time, and equates this empirical situation to the current crisis. But there is one difference between the Great Depression and now, I wasn't around for the Great Depression.

Ebeling is correct in his assertion that exact quantitative forecasts can not be made. But to state that "virtually no one knew where the process was leading" is close to implying that it can not be done at all, to any degree..."Because it depended upon the 'complex phenomena' of individual decisions, political policy choices, ideological influences, and everyday actions based on the expectations held at each moment in time....We will know all the answers -- when some future economic historian (maybe even an "Austrian") writes the history of our times, and tries to tell those future readers how it all happened and why"

That enough of these details can't be known to get a very good sense of the direction of trends in an economy is simply untrue for all cases.

For example, the current crisis began with problems in the housing market and mortgage markets.

In 2004, New York Federal Reserve economists Jonathan McCarthy and Richard W. Peach wrote a paper Is There A Bubble in The Housing Market Now? Their answer was decidedly, "No.

I issued a reply to their paper, at that time writing under a pen name because of other business commitments:

...the record climb in housing prices is, indeed, a bubble... the Federal Reserve study fails to consider past declining interest rates as a cause of the bubble. The faulty conclusions reached by Federal Reserve economists Jonathan McCarthy and Richard W. Peach may make many potential new home buyers comfortable about a purchase, when, in fact, we are very near the top of a housing market that will experience substantial declines in prices...

They reach the conclusion that because of ....[the] "fundamental factor" of low nominal interest rates, higher housing prices are justified.

But does this mean real estate prices will not drop? Our answer is decidedly no. Indeed, McCarthy-Peach report that "since 1995, real home prices have increased about 36 percent, roughly double the increase of previous home price booms in the late 1970's and late 1980''s." We view this increase as largely the result of the Federal Reserve's lowering of interest rates and the pumping of liquidity into the banking system, thus producing the byproduct of higher housing prices. But by incorporating falling nominal interest rates as a "fundamental factor" that can not be a cause of a bubble, McCarthy-Peach have literally defined the cause of the current bubble from being taken into consideration....

Further, the current structure of many mortgage loans whereby no money down is acceptable and/or adjustable rate mortgages are popular, sets up the possibility that many may walk away from current mortgage commitments down the road as interest rates begin to climb. Indeed, as ARM's rates become more and more burdensome and as housing prices begin to decline, walk away situations are likely to become quite prevalent, thus adding even more downward pressure to the housing market.

It is our conclusion, then, that by defining nominal interest rates as a fundamental factor and not as the Fed induced causal factor of the real estate boom, and by completely ignoring the structural features of current mortgage loans, McCarthy and Peach have blinded themselves to the real estate bubble that does exist. They have set themselves up for perhaps making the worst economic prediction since Irving Fisher declared in 1929, just prior to the stock market crash, that "stocks prices have reached what looks to be a permanently high plateau."

Like, I said, you can certainly get a good sense for trends, if you really understand theory. There were no predictions on my part as to date or degree of any collapse (as Ebeling would appreciate), but certainly the trend was accurate and would have protected anyone taking my analysis to heart from jumping into the housing market.

The recent downtrend in the stock market also didn't take me by surprise. Here are my real time posts using nothing but Austrian theory:

See here,here, here, here, here, here, here and here.

It is impossible to point to exact dates, degrees of market movements, but to say,"...neither Austrian Economists nor our Neoclassical and Chicago and Rational Expectations 'colleagues' know what is happening in the economy..." is going too far. It pays to be humble when making forecasts even of qualitative trends, because of the complexity of an economy, but it does not mean that they can not be made with appropriate caveats.

To give another example, if price controls are placed on an economy during a raging price inflation, it would not be too bold a situation for an economist to say that shortages are very likely to arise, without going into the specifics of when and where such shortages will occur.

Economics is not a science that can only be used by historians. It is very valuable in making sense out of current goings on. It is the econometricians who take it to absurd levels in the impossible exactness of their forecasts using faulty mathematical techniques. Thus, we shouldn't throw the forecast baby out with the econometricians bathwater, they are two very seperate and distinct matters.

Robert Wenzel is an economic consultant and Editor & Publisher of EconomicPolicyJournal.com. He can be reached at rw@economicpolicyjournal.com.