Predicting Major Economic Events with Accuracy: A New Framework for Scientific Macroeconomic Models

• DOI: http://doi.org/10.1111/ajes.12096
• Author: James J. Wayne
• Date: 01 March 2015
• Published date: 01 March 2015

Predicting Major Economic Events with

Accuracy: A New Framework for Scientific

Macroeconomic Models

By JAMES J. WAYNE*

ABSTRACT.

1

Despite intense studies over the last several hundred years,

the questions about causes, forecasting, and prevention of economic

crises remain unsolved. The poor performance of macroeconomic

models during the Great Recession of 2008 has forced many economists

to reexamine macroeconomic theories and search for credible alternatives

to the agent-based and general-equilibrium models now currently used

by most economists. This article derives a new category of

macroeconomic model and applies it conceptually to explain the causes

of economic crises. This model, known as the indeterministic balance

sheet plus (IBS1) model, is a special breed of accounting models. It takes

an indeterministic view of future balance sheets. This article proposes a

classification of causes of economic crises using IBS1models to analyze

balance sheets of key economic sectors. Most economic crises are caused

by mismanagement of balance sheets by key economic players, not by

any fundamental flaw of capitalism. The frequency of economic crises can

be minimized by proper risk management practices, but economic crises

can never be completely eliminated. Historically, treating mismanagement

of balance sheets as the main cause of economic crises is a generalization

of Austrian business cycle theory, Fisher’s debt deflation theory, and

Minsky’s financial instability hypothesis.

1. Introduction

Conjectures about the causes of the Great Recession of 2008 have been

in newspapers, magazines, and research reports ever since the start of

the recession. From more or less the same set of facts, people drew all

*An independent researcher specializing in the foundations of economics that have

emerged from quantum physics. Email: jjwinterpretation@gmail.com

American Journal of Economics and Sociology, Vol. 74, No. 2 (March, 2015).

DOI: 10.1111/ajes.12096

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C2015 American Journal of Economics and Sociology, Inc.

kinds of conclusions. Even the official Financial Crisis Inquiry Commis-

sion could not reach a unanimous conclusion.

The reason for so many different opinions is that the research on

what caused the Great Recession depends on the purpose of your

research, the way you analyze the economy, the data set you use, the

economic theories and analytical tools you use, and the time frame you

focus on. The historic facts happened in four-dimensional time and

space. In social science, these historic events are chained in an indeter-

ministic way. In order to make sense of the complicated historic reality,

we are forced to make simplified mental models to focus on just things

we are interested in. Therefore, although historic data are the same, our

simplified mental models are very different. For example, if one would

like to learn a monetary policylesson, one might conclude that the Fed-

eral Reserve kept interest rates too low between 2002 and 2004, which

fueled the housing bubble. If one would like to learn a mortgage

underwriting lesson, one could conclude that poor mortgage under-

writing was a major cause of the recession.

Since economics is fundamentally a forecasting science like physics,

this article is focused on learning a lesson about how to forecast a

recession in advance, using a value-free approach that is theoretically

independent of personal opinions. Wealso limit causes mainly to quan-

tifiable balance sheet data from historic national accounting and corpo-

rate financial filings.

Economic crises have plagued humanity sincethe dawn of capitalism

(Burns and Mitchell 1946; Friedman and Schwartz 1971). Despite

intense studies over last several hundred years, the questions about

causes, forecasting, and prevention of economic crises remain

unsolved. Although every professional economisthas just lived through

and witnessed the Great Recession of 2008, the causes of this most

recent recession remain controversial. The reason economists have

failed to reach a consensus about the causes of the Great Recession of

2008 is that current mainstream economics does not provide a reliable,

value-free, and universal framework to analyze and explain past eco-

nomic events. The leading macroeconomic models in 2014 treat the

Great Recession as an external shock to an economy that was pre-

sumed to be in equilibrium. In other words, the current models define

away the possibility that crises arise from within the system. By

The American Journal of Economics and Sociology420

definition, those models could not offer any insight into the causes of

the Great Recession.

A forecasting model in science requires the model to be logically

self-consistent, reasonably precise in its predictions, truthful in its

abstraction from reality, accurate in capturing key dynamics, and based

on a sound theoretical foundation.

For example, Sir Isaac Newton proposed a solar system model in his

book Principia Mathematica based on laws of motion and the law of

gravity. Newton’s model is an excellent example of what a scientific fore-

casting model should be. We are still using Newton’s model today, except

that we are now using differential equations, which are mathematically

equivalent to Newton’s highly sophisticated geometric derivations.

Another example is the Bohr (1913a, 1913b) model of atoms. The

Bohr model has all the features of a scientific model, except it has a

weak theoretical foundation. Bohr proposed his atom model in 1913

while the full-blown quantum mechanics was established much later in

1925. The Bohr model is a landmark achievement in the history of sci-

ence. Even though the Bohr model can give some highly accurate fore-

casts about hydrogen atoms, we no longer use the Bohr model today

because it lacks a soundtheoretical foundation.

Should we evaluate forecasting models in the social sciences by the

same scientific standard? This author (Wayne 2005, 2013a, 2013b,

2014a, 2014b) has argued that we should set the same scientific stand-

ards in the social sciences as in the physical sciences by using what I

call the Fundamental Equation of Economics (FEOE) and physics laws

of social science. FEOE, similar to Schroedinger’s fundamental equation

in quantum mechanics, implies that 1) outcomes are indeterministic

and are expected to occur according to probability distributionsthat are

discovered empirically, 2) variability is mostly caused by indeterminacy

within a system rather than from unknown external agents, and 3)

while the behavior of individual units (a photon or a human) is unpre-

dictable, the law of large numbers enables accurate predictions of

aggregate behavior.

The Fundamental Equation of Economics (FEOE) is this:

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A New Framework for Scientific Macroeconomic Model 421