Who predicted the bubble? Who predicted the crash?

AuthorThornton, Mark

Science is prediction.

--Motto of the Econometrics Society

Those who have knowledge, don't predict. Those who predict, don't have knowledge.

--Lao Tzu, sixth-century B.C. Chinese poet

Predicting economic behavior is inherently difficult. As Niels Bohr joked, "Prediction is very difficult, especially if it's about the future." (1) People's economic actions are subject to choice and change, unlike the subject matter of the physical sciences, which has fixed properties. Therefore, the future must remain uncertain. Predicting the economy as a whole is fraught with additional dangers and complications, and all leading indicators of economywide change either do not have or eventually lose the capacity to predict the future accurately. As Paul Samuelson once quipped, "Wall Street indices predicted nine out of the last five recessions" (1966, 92). In light of these difficulties, economists have taken widely divergent positions on prediction.

Many modern mainstream economists, like their colleagues in the physical sciences, view prediction as the essence of science. If you cannot predict with a high degree of accuracy, then you are not being scientific. You must put your science to the empirical test and pass that test. The dominance of positivism in economic methodology encourages economists to worry less about the logical consistency of their models and to concentrate more on the development of models that exploit historical data in making predictions. Government and business economists then use the models to forecast variables such as gross domestic product (GDP), interest rates, unemployment, company sales, stock prices, housing starts, and demographic changes.

There is also substantial support for the position that we cannot predict and that economists have a terrible forecasting record. With respect to the recent bubble and bust, Mike Norman put this view of economists in perspective: "I'm an economist. Big deal, right? Until last year, economists got even less respect than Wall Street analysts; now, we're just a notch above. Admittedly, this reputation is well-deserved, because it comes from our less-than-stellar ability to get economic forecasts right. With all of that data and plenty of powerful computing ability, you'd think we could produce better forecasts. Heck, even the local weatherman puts us to shame" (2003).

The "street," having witnessed countless forecasts go wrong, is naturally suspect. As Lindley Clark once noted in the Wall Street Journal, "Economists have a great deal of trouble predicting the future, and it's unlikely that this unhappy situation ever will change" (1990). Indeed, some economists think that forecasts are akin to "magic" and that such magic is contradicted by the very essence of economic science. Deirdre McCloskey has expounded on this view of economic forecasts:

Economics is the science of the postmagical age. Far from being unscientific hoobla-hoo, economics is deeply antimagical. It keeps telling us that we cannot do it, that magic will not help. Only the superstitious think that profitable forecasts about human action are easily obtainable. That is why economics, contrary to common sneer, is not mere magic and hoobla-hoo. Economics says that forecasts, like many other desirable things, are scarce. It cannot be easy to know what great empire will fall or when the market will turn. "Doctor Friedman, what's going to happen to interest rates next year?" Hoobla-hoo. Some economists allow themselves to be paid cash money to answer such questions, but they know they cannot. Their very science says so. (1992, 40) Though agreeing in the main that forecasting has questionable value, Michael Bordo (1992, 47) claims that forecasting has some scientific and practical value and is not all just snake oil and magic. He notes that not all economists have been such dismal failures as forecasters: Richard Cantillon made correct predictions about John Law's Mississippi Bubble system based on economic theory, and he made a fortune as a result.

Others, such as the famous Chinese philosopher Lao Tzu, are skeptical about the prospects for prediction but do not altogether reject the possibility of accurate prediction. They merely restrict themselves to hypothetical and qualitative prediction. Foremost among this group are the Austrian school economists, who reject the notion of fixed relations between human-controlled variables and even the idea that data can be used to "test" an economic theory. Austrian economist Ludwig yon Mises rejected the general notion of forecasting and claimed that economics can provide only qualitative predictions about particular polices.

Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only "qualitative." It cannot be "quantitative" as there are no constant relations between the factors and effects concerned. The practical value of economics is to be seen in this neatly circumscribed power of predicting the outcome of definite measures. (1962, 67) The problem of predicting (with the goal of preventing) stock-market bubbles and crashes is especially important, not just because busts result in huge financial loses for some investors, but because many of these extreme financial cycles can disrupt the financial system and lead to real economic contractions (Mishkin and White 2003). Unfortunately, economists have yet to develop a generally accepted view of bubbles and have little to offer in predicting them.

As a case in point, a conference sponsored by the World Bank and the Federal Reserve Bank of Chicago (with papers published in Hunter, Kaufman, and Pomerleano 2003) featured leading economists who considered the causes of asset-price bubbles. Among the participants, Randall Kroszner of the University of Chicago and the President's Council of Economic Advisors claimed that uncertainty about the past makes real-time identification of bubbles problematic. "The research record on asset-price measurement is far from being sufficient to build a policymaker's confidence" (Halcomb and Hussain 2002, 1). The governor of the Bank of France, Jean-Claude Trichet, said that determining asset-price bubbles is difficult and that government policy might do more harm than good because people "may become involved in riskier projects without having consciously taken the decision to accept greater risk" (2). Fredrick Mishkin and Eugene White reexamined the past hundred years of stock-market crashes and suggested that ignoring stock-market crashes and concentrating on the economy is the best policy to avoid severe financial meltdown most of the time. Kunio Okina and Shigenori Shiratsuka found that the Bank of Japan should have used aggressive monetary policy following the Japanese bubble, but that it could not do so because of the fundamental and ongoing weakness of the Japanese banking and financial system. Santiago Herrera and Guillermo Perry concluded that the United States helped to export bubbles to Latin American economies.

Are bubbles "rational"? In this same World Bank conference, John Cochrane of the University of Chicago argued that bubbles are rational because holding shares of high-tech companies is like holding cash. Ellen McGrattan and Edward C. Prescott of the Federal Reserve Bank of Minneapolis found that no bubble existed in 1929, and stocks were actually undervalued then. Allan Meltzer of Carnegie Mellon University made the reassuring claims that bubbles could be explained, that buyers and sellers are rational during bubbles, and that "expansive economic policies can compensate for any deflationary impulse on output prices coming from asset prices" (3, emphasis in original). Werner De Bondt, however, averred that psychological factors play an important role in short-term bubble behavior.

Michael Bordo and Antu Murshid found that bubbles are transmitted regionally during some periods and internationally during others. Franklin Allen and Douglas Gale found that international stock linkages can either increase or decrease the extent of asset bubbles. Steven Kaplan of the University of Chicago found that high-tech stocks were highly valued because people believed they would reduce transactions costs, but stock-market values fell when people no longer held that belief. Marvin Goodfriend of the Federal Reserve Bank of Richmond said that central banks should not target asset prices, but Michael Mussa of the Institute for International Economics said that sometimes they should. Stephen Cecchetti and Hans Genberg argued that targeting asset prices might help. There was agreement that if asset bubbles do exist, then they are inevitable, whether they are rational or not. (2) Obviously, these conflicting and contradictory findings leave much to be desired with respect to our understanding of stock-market bubbles.

Therefore, when we ask who made accurate predictions about the economy and who did not, we ask a question that goes beyond the issue of the day and touches on a fundamental issue of economic methodology. Naturally, my survey in this article does not represent a comprehensive accounting of all predictions. Its point of departure is that most people--whether they were investment analysts, advisers, fund managers, investors, pundits, or professional or academic economists--did not predict the recent bubble and crash. Not only was the number of correct predictions small, but for certain reasons such predictions for the most part were made in venues of relatively small market share. In canvassing for correct predictions, I pay special attention to eliminating perpetual predictors of doom (that is, those who are always predicting bear markets, stock-market crashes, and depressions) and to analyzing the rationale for...

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