Witches, Cargo Cultists, and Macroeconomists

October 1, 2008

Returning to the question of whether the study of Economics is fundamentally different from witchcraft, I will recount a story told by Pete Boettke, a Professor at GMU, to describe the method of the “Austrian school” of Economics.

Imagine that an alien being is studying the behavior of Earthlings by observing the activity at Grand Central Station as people commute to and from work. Every morning at 9 am, these giant metal things spew out hundreds of people, who immediately start running around in all directions. Then, at 5 pm, these same metal things swallow up all the people again. This goes in regular cycles, it happens for five days in a row, and then for two days it doesn’t happen. Eventually the aliens are able to make good predictions about how many people are going to be spit out or swallowed up by the metal things, even though they have no theory about why the events they are looking at take place. But then one day, at 9 am on the first day of a cycle, nobody comes out of the metal things. The aliens have no idea why their predictions went wrong. For us, the answer is easy: this Monday is a holiday, and people don’t go to work on holidays.

The aliens’ model, which makes predictions without knowing or caring why people people act the way they do, has some virtues. It’s very simple, and generally makes good predictions. Yes, it’s unrealistic to put forth a model that posits no internal motivation for human action, but under normal circumstances, it doesn’t matter.

Something like this is what non-economists are getting at when they shout “Hey! That’s not realistic!” in response to an economic model. “True,” economists respond, “but my model makes good predictions.” And economics does make pretty good predictions, except when it doesn’t. Prior to the 1970’s the Phillips curve was supposed to show that there is a trade-off between unemployment and inflation. Then the late 70’s combined high unemployment and high inflation, and economists revised their model to say that the trade-off only applies to the short-term. Or take interest rates and inflation. A central bank can cause higher inflation by lowering interest rates. Except in Japan in the 1990’s, which experienced deflation despite setting interest rates near 0%. That’s the “lost decade,” Japan’s prolonged recession. You won’t believe me on this if you weren’t there and paying attention, but two years ago, respectable economists were claiming that we could never have another huge recession like in the 1930’s, because our understanding of the economy and the role of the central bank was so advanced.

Macroeconomic models are good at making predictions, as long as the economy is not in a recession. Which, incidentally, is when we need the models to function. Still, I wouldn’t say macroeconomics as so much like witchcraft as it is like a Cargo Cult. After World War II, some Pacific islanders were said to have believed they could get large crates of cargo to arrive, like the Americans did, by imitating the look of their uniforms, runways, radios, and control towers. Like the Cargo Cultists, macroeconomic planners try to recreate the data that they observe in well-functioning economies, not understanding that the data they observe in their models are the result of good economic conditions, not the cause.

Making economics useful requires more than just trying to imitate successful economies. This is what Boettke means when he writes, “there may be macroeconomic problems, but there are only microeconomic solutions.” There is economics that works, but it’s not the stuff that comes from data mining. Rather, the proven economic models are those which make intuitive sense, saying something like “when the risk of an investment goes up, people demand higher interest rates on their money to compensate” and works through the consequences of that insight. Again, an obvious point, but it’s not how a lot of macroeconomics is done. See, e.g., Alan Blinder.

I don’t see how anyone can have any confidence in their predictions about the path of the US Economy, whether they say that everything is going to be just fine or that we are headed for disaster. Without a theory to explain why the collapse of certain major financial institutions means the end of credit for everybody, I don’t see how we can accept the claim that it does. Macroeconomics has a lot of work to do to prove that it is relevant.

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