Reviewed February 2021

ECONOMISTS AND ECONOMICS

Abstract:  Economics is a social science and not a hard science like chemistry or physics and there are no constants.  Few lasting principles have been discovered despite the use of complex economic models, equations and advanced statistics.  Economists often differ greatly from each other on what theories and models best explain economic growth or how to produce it.

Investors are often offered theories, data and predictions made by academic economists, financial industry economists, Federal Reserve economists, and government economists.  Investors are also presented with econometric data on a daily basis in the financial media and moves in markets are often attributed to changes in macroeconomic data.  Federal Reserve and banking industry economists along with Washington politicians propose policies and pass legislation incorporating economic perspectives and arguments and make assertions and predictions they believe to be true.  Investors often turn to economists and economic information in an attempt to make better and more profitable investment decisions.  Consulting economists is unlikely to help.  The rest of this article examines why that is so.

ECONOMIC EVENTS AND INVESTMENT RETURNS ARE NOT PREDICTABLE.  Past asset class returns are the result of unpredictable economic events.  Economic data are dependent upon unpredictable events.  Passive and index investment strategy focuses on past risks and returns and variations between and within groups of asset classes.  It puts little if any analysis into what produced the numbers and is historical in nature.  Past economic and return statistics are the results of events in the real world in the past.  These events include competitive advantages or disadvantages with other nations, new technologies and industries that arise, new investment instruments like derivatives and CDS's, changing societal values regarding consumption and debt, changing central bank policies on money supply and interest rates, changing regulation, changing currency exchange values, bubbles and crashes, and countless other factors.  These events are wholly unpredictable yet influence economic variables which in turn influence forward investment risk and return.

This fundamental principle, that unpredictable events in the real world influence economic conditions which in turn influence asset class risks and returns, is well-illustrated by equity returns in Germany and in Japan for 1900 through 2000 (Dimson et al., "Triumph of the Optimists", 2003).  German equities returned 0% from 1900 through 1950 then grew over 36 times in price over the next 50 years.  Japanese equities returned 0% from 1900 through 1950 then grew over 89 times in price over the next 50 years.  It certainly makes sense that losing a war or two would seriously harm a country's infrastructure, economy, and financial markets.  Yet, in 1900 at the start of the new century optimism was high for a peaceful and prosperous century, unlike the 1800's, and even as late as 1913 there was no expectation of WWI to be found in the press.  Economists and investors obviously aren't likely to know what economy influencing events are coming up before they occur.

ECONOMICS OFFERS NUMEROUS AND SOMETIMES CONTRADICTORY THEORIES.  Theories in economics are theories, mild speculations on how economies are working or should work.  Some are expressed with certainty, others with caution.  Before the advent of econometrics in the early part of last century and the computer in the second half of last century economic thinking was considered part of moral or political philosophy.  It was viewed as a theoretical endeavor or philosophical endeavor with potential practical applications but it was not viewed as a science.  Economics was called political economy.  Economics is a social science, like psychology, and, as such, is fundamentally different from the natural sciences and not at all as precise as conventional science.  Prior to WWII few economic treatises contained numbers or data.  Today economics presents itself as a science through the widespread use of equations and complex mathematics but it remains a conglomeration of conflicting opinions and theories and ever varying data.

Economists frequently disagree amongst themselves on which theories should be used to explain past events.  In fact, they often vehemently disagree.  Economic theories and data to support them have been advanced for everything from totally free unregulated markets to totally centralized government economic planning.  For example Dr. Ben Bernanke, former Fed chairman, believes he has an explanation for the Great Depression and how it could have been prevented.  A highly esteemed economist who lived through that period, Benjamin Anderson, presents a totally opposite and very well-documented view in "Economics and Public Welfare" (1979).  Today, we have a small percentage of proponents of Austrian economics who emphasize classical free market pricing systems with minimal central bank and monetary intervention while Keynesian economic theory, largely dominant today, argues that "borrow, print, and spend" models will stimulate demand and grow economies faster in the future.  In the view of many economists, e.g. Paul Krugman, stimulation by fiat money creation and ever rising debt supposedly results in increased production and preceeds production.

The majority of academic economic models assume a small and simple list of causative variables, tight orderly models that can be built in equations, rational economic actors, efficient price setting, and market equilibrium.  But, a raft of historical examples and research shows that humans are far from rational and markets are prone to fads, manias, panics, and crashes.  Most contemporary academic models assume that governments and central banks can employ economic statistics and models to engineer, control and stimulate economic growth yet there is little persuasive long-term historical data to support their effectiveness and much to suggest that central banks are more likely to weaken or destroy economies.  Academic models and research help economists get published and, if adroit at politics and positioning, enable a few economists to enjoy public prominence and power and, sometimes, wealth.

Dr. Ben Bernanke apologized for the supposed mistakes of the Fed in the Great Depression and assured America that deflation would not happen in the US again.  In simple terms he argued that deflation, a decline in prices, leads to depression.  Actually, the US economy, due to deflation, showed average long-term growth in the 1930's.  The Fed likes to present itself as able to understand and largely control economic growth.  Two academic economists with extensive consulting experience for the Fed, Andrew Atkinson and Patrick Kehoe, published research examining the relationship between deflation and depression and real GDP output across 17 countries for more than 100 years.  Their main finding is that the only episode where there is a link between deflation and depression is the Great Depression during 1929 through 1934.  In their total sample of 73 deflation episodes 89% had no depression.  There are many more episodes of deflation with reasonable growth than deflation with depression and many more periods of depression with inflation than with deflation.  Atkinson and Kehoe were both fired by the Fed in Fall 2013.  Apparently, these facts were unacceptable to the Fed.

There is simply no universally agreed upon body of theories that constitutes economic thinking and viewpoints are continuously changing.  Paul Samuelson received a Nobel prize in 1970 for his theory that government can fight economic downturns by boosting spending and cutting taxes.  In 1976 Milton Friedman received the Nobel prize by focusing on the risks of increased spending and easy money and he emphasized the importance of controlling money supply growth and keeping it in line with economic growth.  In 1995 Robert Lucas, Jr. received the Nobel prize for showing that large-scale government attempts to stimulate the economy are unlikely to succeed over time.  In spite of historical evidence showing that deflation rarely leads to depression in 2008 Paul Krugman received the Nobel economics prize for arguing that large-scale government spending should be used to prevent a sustained depression.  Alan Greenspan, Fed Chairman from 1987 through 2006, was a strong proponent of sound money and the gold standard in the 1960's.  Yet, during his long reign as Fed chairman, 1987 through 2006, Greenspan changed his tune and pursued cheap money policies.  After resigning the chairmanship he regressed back to his earlier views and became a critic of current cheap money policies as of 2016.  The bottom line is that very few economists predicted the 2008 financial crisis or its repercussions regardless of their theoretical position.  Further, the Fed's economic theories as to how to resolve the 2008 credit crisis have resulted in little real world benefit to most Americans since 2008 according to US government data.  The US Bureau of Economic Analysis the US economy grew about 25% between 2009 and 2020, very close to its growth in the 1930's.  The Fed's ultra-low interest rate policies and an increase in US Treasury, corporate, and personal debt have very substantially benefitted asset prices in stocks, bonds and real estate, big banks and net worth for the top 1% of Americans.

The 2013 Noble prize in economics was split between three economists with very different views of the world, Eugene Fama Sr. of DFA, Bob Shiller of Yale, and Thomas Sargent of NYU.  Fama believes markets pretty much get the price right for assets most of the time and sees markets as largely rational and efficient information processing mechanisms and equilibrium seeking.  He doesn't believe in mispricing and bubbles.  Shiller sees markets as prone to irrational exuberance and human emotion and prone to bubbles.  Sargent sees markets as working well and damaged by central bank interventions.  After receiving the prize Shiller penned an article, "Is Economics Science".  He dodged the question a bit but made two revealing points:  1.)  Why is it called a prize in "economic sciences" rather than just economics?  The true Nobels in science are not awarded in the "chemical sciences" or the "physical sciences".  They are true sciences where hypotheses can be clearly proven or disproven by scientific methods and any capable scientist.  That is decidely not so in economics.  2.)  He argues that economics is necessarily focused on setting policy rather then developing proven means for stimulating economic growth.

Economics aims to generate practical solutions to economic problems.  Given the internet/tech bubble of the late 1990's and the 2003 through 2007 bubble in stocks and housing and the 2008 financial crisis the Fed may need to work a bit more on the practical application of its theories.  Sargent, after receiving his Nobel prize, blasted the central banks stating that "historically, there is no reason to fear deflation".  Sargent proposes that we all benefit from lower prices and that central bank targeting of a 2% inflation rate simply makes "bad debt good debt".  The Fed's relatively recent designation of 2% inflation as desirable has no historical data to back it up.  Sargent opines that a return to the gold standard would not be so foolish.  Most economists don't support this viewpoint and support government created money which can also be created infinitely.  It's hard to argue that economics or the Swedish central bank's Nobel prize in economics resembles anything in science or anything new when Nobel prize winners often hold completely contradictory theories.

THE USE OF ADVANCED STATISTICS DOES NOT MAKE ECONOMICS A SCIENCE.  As noted above modern economics has been seduced by the idea that equations and numbers make the field more scientific.  For economics to be considered a science we would first need to see that economic ideas can be clearly defined and quantified, that a hypothesis can be formed and empirically confirmed or disconfirmed, and that a body of empirical knowledge can be built on its findings.  We would also need to see that economists could use that body to predict future economic events and not just come up with theories and data to explain them after the fact.  Economists cannot establish control groups or manipulate multiple variables in an experiment since economic events occur in a highly complex and ever-changing global system.

THE NOBEL PRIZE IN ECONOMICS IS AN AWARD FROM THE SWEDISH CENTRAL BANK AND IS NOT AT ALL THE SAME AS NOBEL PRIZES IN SCIENCE.

The belief that economics has its own Nobel Prize like scientific fields is erroneous.  The five real Nobel Prizes, physics, chemistry, literature, peace, and medicine/physiology, were set up in a will left by the dynamite magnate Alfred Nobel when he died in 1895.  The Nobel in Economic Sciences was established and funded by the Swedish Central Bank in 1968 to celebrate the bank's 300th anniversary and not coincidentally give economics a scientific patina.  Members of the Nobel family are amongst the harshest and most persistent critics of the Nobel economics prize and have repeatedly called for the prize to be abolished or renamed.  Alfred Nobel's great-grandnephew, Peter Nobel, has been a vocal critic of the economics prize and calls it "a PR coup by economists to improve their reputation."  In 2004 three prominent Swedish scientists and members of the Nobel committee published an open letter in a Swedish newspaper.  In it they argued that the economic Nobel diminishes the value of other Nobel prizes, should be disassociated from it, and that the achievements of most of the economists who win the prize are so abstract and disconnected from the real world as to be utterly meaningless.

The famed Austrian economist Friedrich von Hayek in his 1974 speech after receiving the Nobel prize at the Nobel Banquet stated that "the Nobel Prize confers on an individual the authority which in economics no man ought to possess.  This does not matter in the natural sciences.  Here the influence exercised by an individual is chiefly an influence on his fellow experts and they will soon cut him down to size if he exceeds his competence.  But the influence of the economist that mainly matters is an influence over laymen:  politicians, journalists, civil servants, and the public generally."  His speech was entitled, "The Pretense of Knowledge".  That phrase probably says all we need to know about economics.

Scientific American (November, 2011) carried an article entitled, "Why Economic Models Are Always Wrong".  Model building is widespread in the hard sciences and flaws in scientific model building have been well studied.  Scientific hypotheses and models are conceived then tested and retested by other scientists to see if they can be replicated.  This is standard scientific method.  Hypotheses can be clearly proven or disproven by a body of highly qualified professionals.  However in economics and finance a problem arises because human beings aren't all that predictable and financial markets, technologies and economic structures are always changing and are not predictable.  Flaws in economic models or the historical data turn out predictions which are incorrect or not applicable to new circumstances because circumstances have changed.  Often thse economic models are modified or contrary evidence is simply ignored.  The authors conclude that "in finance they just keep on recalibrating and pretending the models work".  There is simply no agreed upon body of evidence that constitutes a science of economics nor is it likely there ever will be one.

ECONOMIC PREDICTIONS ARE NO BETTER THAN CHANCE GUESSING.  For economics to be considered a science, we would want to see a series of rules which would allow us to predict economic events in advance and at least confirm or disconfirm our hypotheses.  We have extensive anecdotal and empirical evidence that economists cannot predict economic events better than chance guessing no matter what economic school they belong to.

Sherden ("The Fortune Sellers, 1998) reviewed leading research on economic forecasting accuracy contained in 12 studies published between 1979 and 1995.  His review included forecasts by the Council of Economic Advisors which advises the president and the Congressional Budget Office, a non-partisan government accounting agency.  He found that economists who directly or indirectly run the US economy were worse than chance in predicting future economic turning points.  One study Sherden reviewed looked at included 5000 forecasts by fifty leading economic forecasters.  It concluded that "the predictive value of detailed forecasts reaching out further than a few quarters ahead must be heavily discounted."  He found that economic forecasts were about as accurate as guessing that next year will be the same as this year, that there were no economic forecasters who consistently lead the pack, no theories that produced consistently superior predictions, that complex statistical models did no better than simple models, and that there was no evidence that economic forecasting skill had improved over the prior three decades.  He concluded that economic forecasting failed because economies are complex nonlinear adaptive systems which have no predictability.  The Fed's Dynamic Stochastic General Equilibrium (DSGE) model, the backbone of the Fed's policies as of 2019, assumes equilibrium and growth can be achieved through careful financial tinkering by central banks.  The Fed model has been consistently wrong and almost always overoptimistic.

Other studies have reached similar conclusions.  One study found that Federal Reserve economists did worse than chance in predicting significant turns in economic growth and inflation.  A 2001 IMF study of 63 countries looked at economists' recession forecasting prowess and concluded that "The record of failure to predict recessions is virtually unblemished."  A repeat of the study found that exactly zero economic forecasters saw the 2009 recession coming.  Dr. Ben Bernanke was consistently wrong as chair of the Federal Reserve from 2006 through 2014, first claiming that subprime mortgages would have no effect on the economy, then that the subprime impact was "contained" and no recession would result, and then that the Fed had an $800 billion war chest that could fix any economic problem that might come from their failure.  As of early 2019 the Fed had approximately $4 trillion of former bank assets on its books that it purchased from big banks in 2008 and 2009 to give them cash and the US Treasury had pushed about $12 trillion into the US economy that no one earned or paid in taxes since 2009.  It's not clear that a lasting recovery has been achieved but higher securities prices have definitely been created.

A paper published online by Wharton in May 2009 examined why economists failed to predict the financial crisis that struck America in 2008.  In a highly critical piece, "The Dahlem Report", eight economists argued that academic economists were too disconnected from the real world to see the crisis coming.  They condemned a growing reliance on mathematical models that improperly assume markets and economies are inherently stable, disregard the way economic players make decisions, assume rationality at all times, and underestimated the risk of derivatives and massive creation of cheap money.  I think it fair to say that we do not yet fully understand with any certainty how to manage and grow economies or avoid recessions or depressions.  Our understanding of economies and the factors that influence them may be better than 200 or 2000 years ago or it may not be but it definitely hasn't enhanced our ability to predict and control economies as of 2019.

ECONOMISTS HAVE A CONFLICT OF INTEREST WITH CONSUMERS OF ECONOMIC INFORMATION.   According to the US labor department there were around 15,000 non-academic economists in the US in 2008 with a median salary of roughly $83,000 and the top 10% made more than $149,000 annually.  Economists make their living by doing research, writing, and dispensing economic theories and advice.  A 2014 study reported on Zerohedge developed a scatterplot with a log of Google pages indexed to the names of economists on one axis and their average fee for public speaking on the other axis.  Economists being paid more were, not surprisingly, more often before the public eye although the correlations was only r = .51 for non-academics and r =.34 for academics.  Compensation for speeches clustered in the $10,000 to $50,000 range with bigger names in economics like Ben Stein and Martin Feldstein getting more for public speaking engagements.  Ben Bernanke was paid about $190,000 annually by the Fed.  After retiring in January 2014 he began speaking engagements at $250,000 per one hour speech.  Dr. Bernanke's policies very significantly boosted profits to the financial community after the 2008 financial crisis and for the 2008 through 2014 period.  Not surprisingly most of his speeches are given for and paid for by banks and major financial institutions which benefitted from his policies.

Economists have personal motives for promoting economic theories or making predictions.  Wall Street economists want to avoid driving assets from their financial firm if they work for one and want to spread optimism.  Government economists consistently report data which present the economy in the best possible light, a desire of politicians.  Government statistical agencies have modified their methodology numerous times over the last 30 years with almost all modifications designed to make their statistics and the US economy look better than it did previously.  Presidents and politicians promote policies which will maximize their chance of staying in power.  Today that means massive borrowing and spending which may be harmful to the economy long-term but many economists promote this.  Academic economists largely live in a "publish or perish world" and do research employing assumptions and models with the highest probability of being published in peer reviewed journals.  This tends to support consensus views and models and leads to what is called groupthink.  A study published by the Fed in 1997, "Rational Bias in Macroeconomic Forecasts", found that forecasts may also be inspired by a desire for publicity or to curry favor with employers and funding agencies or generate business through media exposure.  If economists are wrong they can just ignore their last failed prediction or rationalize it away.  There is little or no personal accountability, no fines or penalties, and little likelihood of professional censure if they are incorrect even when prognostications fail and harm investors or the economy.

CONCLUSION:  Economic explanations of events and forecasts persist because the investment public wants certitude and wants to believe someone understands how to create wealth and bring lasting prosperity.  Unfortunately, a sober assessment of economists suggests that the public is misplacing their trust.  The field of economics is something of a paradox for investors.  Though economic variables have a profound effect on investment returns long-term knowing economic theory and research doesn't enable investors to invest more profitably or determine what investment risks and returns lie ahead.