|This essay by Hernán Cortes Douglas was written in December 2001. It was reprinted in:
Prechter, Robert R. (2003). Pioneering Studies in Socionomics. Gainesville, Georgia: New Classics Library, pp. 256-265 (Note: The book is also available for purchase as part of a two-volume set.)
“This expansion will run forever.1 So said an MIT professor of economics in The Wall Street Journal. Think about it. A respected leader in the field comes to a conclusion about economic behavior that defies the entirety of history. Since that article appeared on July 30, 1998, we know that its breathless conclusion also failed to accommodate the future. Nor was this opinion unique at the time. Ninety-eight percent of economists in The Wall Street Journals New Year’s poll of 2001 said they expected continued expansion throughout the year.
This type of forecasting error is hardly a first for academic economists. Examples of our profession’s failure to anticipate economic contractions are legion and span its entire history. The Economist reiterated in its November 29, 2001 issue, “Economists have a dismal record in predicting recession. Some instances have been so glaring and instructive that they beg retelling.”
A Brief Review of Major Failures in Economic Forecasting
To most famed and respected economists of the 1920s, the crash that preceded the Great Depression was utterly unexpected. Fourteen days before Black Tuesday, October 29, 1929, Irving Fisher, America’s best-known economist and Professor of Economics at Yale University, declared, “In a few months I expect to see the stock market much higher than today.” Fisher, a consummate theoretician, a founder of econometrics, and a pioneer in index number analysis, was also a successful capitalist, having invented the c-kardex file system, which he sold for a staggering sum. He had such faith in his economic analysis that he is reported by his son to have lost an estimated 140 million of today’s dollars in the crash.2 British economist John Maynard Keynes, a renowned father of macroeconomics who had amassed fortunes in the financial markets for both himself and Cambridge University, was caught unprepared, shedding a million of todays pounds sterling of his net worth.3
Days after the crash, the Harvard Economic Society reassured subscribers, “A severe depression such as 1920-21 is outside the range of probability. We are not facing a protracted liquidation.” In 1932, after a string of failed optimistic forecasts, the Society closed its doors.
New societies at universities, central banks and independent think tanks have since sprung up. Do they know any more about macroeconomic forecasting than their predecessors?
Since the Great Depression, we have had immense improvements in science and technology. Given seven additional decades of data collection and progress in econometric techniques, one might presume that the forecasting tools of macroeconomics have become vastly more effective than their predecessors of 1929. Yet as recently as 1988, some leading economists went on the record about the profession’s lack of progress. Writing in The American Economic Review, the journal of the American Economic Association, Kathryn Domnguez, Ray Fair, and Matthew Shapiro reported that a modern economist, armed with the latest and most sophisticated econometric techniques, and even using voluminous data that was unavailable in 1929, would have had no idea in 1929 that the Great Depression lay around the corner.
Real results continue to bear out the implications of this conclusion. For example, as one writer observed, “It is hard to imagine any article with worse timing than, say, Asia s Bright Future,4 which appeared in the November/December 1997 issue of Foreign Affairs. The article, by two Harvard professors, appeared as East Asian economies were already melting down and as Japan was staggering through one of the three recessions it has suffered in a decade of financial difficulty. Consider its disutility in light of the fact that the year 1974, a full 23 years earlier, would have been the best time for such a forecast, while 1997, late 1997 at that, was the worst time since the onset of World War II to have made it.
President Herbert Hoover, reflecting in his memoirs on economists’ consensus prior to the Depression for which the public so often blamed him, complained, “With growing optimism, they gave birth to a foolish idea called the ‘New Economic Era.’ That notion spread over the whole country. We were assured we were in a new period where the old laws of economics no longer applied.” Seven decades later, our MIT professor’s prognostications about the ‘New Economy’ echoed those same follies. The justification once again was that we had conquered the business cycle: “As we have the tools to keep the current expansion going,” he wrote, “we wont have [a recession.] We have the monetary and fiscal resources to keep one from happening, as well as a policy team that wont hesitate to use them for continued expansion.5 If that were true, then Japan, with its own dedicated “policy team” of macroeconomists and its world-class kit bag of macroeconomic “tools,” would have prevented the prolonged stagnation that was as evident in 1998 as it still is now.
Mysteries Loaded with Suspects
The Minneapolis Fed, in October 2000, invited some sixty noted economists to a conference to present research papers on the Great Depression. The event attracted a number of macroeconomist luminaries, including University of Chicago professor Robert E. Lucas Jr., the 1995 Nobel Laureate, and professors from the University of Minneapolis, UC Berkeley, Princeton, Carnegie Mellon and other top universities. All that talent brought to bear notwithstanding, the report on the conference in the Minneapolis Fed Review, The Region, concludes on a rather disappointing note. When economists review the facts surrounding the Depression, it says, “they each time come up with another explanation. The Great Depression is a mystery that is loaded with suspects and difficult to solve, even when we know the ending.”6
By and large the explanation of this failure is that economists have been leaning on so-called macroeconomic fundamentals to attempt such predictions. Have they ever succeeded? The historical data say that they cannot succeed; financial markets never collapse when things look bad. In fact, quite the contrary is true. Before contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons. Despite these failures, indeed despite repeating almost precisely those failures, economists have continued to pore over the same macroeconomic fundamentals for clues to the future. If the conventional macroeconomic approach is useless even in retrospect, if it cannot explain or understand an outcome even when we know what it is, has it a prayer of doing so when the goal is assessing the future?
Apparently not. As Lucas candidly observed years ago, “Economic reasoning will be of no value in cases of uncertainty.7 We have learned from Nobel laureate Friedrich von Hayek, his mentor, Ludwig von Mises, and from Frank Knight, a professor of economics at the University of Chicago who taught several Nobel laureates, that uncertainty is normal and pervasive. Given that the future is always uncertain, is Lucas saying that “economic reasoning” has no forecasting value whatsoever? Reasoning per se is not at fault; more and more, it appears that the flaws reside in the conventional economic premises upon which that reasoning is founded.
Toward a New Understanding
What are economists missing? What did they once learn but later forget or neglect? What new studies shed light on the subject? For answers, I suggest looking to the following three subsets of empirical observations that have emerged from disparate sources.
1. Debt drives the business cycle.
Well-known to economists but oddly ignored is the fact that large, sustained increases in money and private sector debt accompany economic booms. Conversely, important contractions in money and private sector debt accompany economic contractions. Fluctuations in private debt levels correlate with stock indices and economic activity in general, especially with respect to trends lasting years or decades. These observations are consistent with the monetary (Milton Friedman) and Austrian (Mises and Hayek) theories of the business cycle, but economists have ceased putting them to practical use. In 1933, Irving Fisher highlighted the correlation in an article in Econometrica, Debt-Deflation Theory of Depressions, which most economists have neglected. Similarly, in a lifetime of work ignored by mainstream economists, post-Keynesian economist Hyman Minsky focused on the financial instability created by expanding indebtedness. In the major boom that ended with the 20th century, private sector debt accumulated at a blistering pace and hit very high levels, especially near the end. Economists again paid scant attention to this phenomenon and again paid the price by missing the reversal.
2. Market indices trace patterned paths.
Ralph N. Elliott, author of The Wave Principle in 1938 and succeeding works,8 established in the mid 1930s that financial markets trend and reverse in recognizable patterns. Their structures are clear and definite in form, although not fixed in time or amplitude. Market movements have different degrees. Patterns of smaller degree link together to form similar patterns at larger degree. Thus, Elliott established that markets are hierarchical. In recent years, physicists who have studied financial markets have discovered aspects of market behavior that are compatible with this insight.9,10
For the past three decades, Robert R. Prechter, Jr. has applied and extended these principles to a wide variety of social phenomena.11 Perhaps most important, his latest book, The Wave Principle of Human Social Behavior and the New Science of Socionomics, has established that markets are “robust fractals,” (termed “quasi-fractals” by physicists Arneodo et al.12). Robust fractals are a special case of the general fractals described by Mandelbrot, having, says Prechter, “a qualitative specificity of form akin to that of definite fractals, such as nested squares, as well as a quantitative elasticity akin to that of indefinite fractals, such as clouds and seacoasts.”13
Because of the form specificity of robust fractals, there is an element of predictability in markets, not in spite of, but because of, their complexity. As one recent example, physicists Anders Johansen and Didier Sornette found that markets proceed unabatedly toward a crash, “anticipating [it] in a subtle self-organized and cooperative fashion, releasing precursory fingertips observable in stock market prices.14 Yet at such times, everything looks rosy to mainstream macroeconomists because stocks have been rising persistently, and output, employment and other standard indicators appear healthy. Economists relying on such “fundamentals” invariably extrapolate the good times into the future (“the crudest form of technical analysis”15), rather than recognize their true import in a patterned world.
If we economists are to advance our craft, we will have to abandon the widespread illusion that financial markets are random walks, as many top business schools, unfortunately, continue to preach, against formidable evidence such as that reported by Andrew W. Lo and A. Craig MacKinlay.16 Markets proceed relentlessly according to a robust fractal, whose components or phases Elliott designated as “waves.” The new theoreticians and social physicists find themselves in good company with classical analysis: Pythagoras’s doctrine called for inquiry into pattern rather than substance to determine the essence of things.17 Such inquiry is now bearing fruit in the macroeconomic field.
3. Changes in economic variables follow stock market fluctuations according to degree.
Changes in the stock market indices precede—they do not follow—changes in economic fundamentals or news about them. Thus, they are a leading indicator of economic activity. Eight decades ago, Wesley Mitchell and the National Bureau of Economic Research recognized this phenomenon, but an inability to recognize different degrees made the breakthrough less helpful than it might have been.
If the changes in markets are hierarchical, then so are the economic changes that follow. This explains why declines in stock indices of very high degree anticipate depressions, while drops of lesser degree anticipate recessions and milder downturns. Paul A. Samuelson, 1970 Nobel laureate, famously quipped, “The market has anticipated five out of the last three recessions,” completely missing the hierarchical nature of markets. It was a clever, but inaccurate, remark. Understanding the hierarchy and chronology of stock market and economic events will allow macroeconomists more accuracy in prediction.
A New Basis for Theory and Modeling
Only two academic economists—Friedrich August von Hayek and Ludwig von Mises—correctly forecast the market break of 1929 and the ensuing Depression.18 Did economists adopt their Austrian theory? Alas, no. They adopted the economics of Keynes, and not the best economics of Keynes.19
In a world of uncertainty, expectations are a critical variable in most financial decisions. Some notable economists have acknowledged that the mental variability of human beings in this regard is missing from the conventional model. “It is acutely uncomfortable,” 1987 Nobel laureate Robert M. Solow wrote recently, “to have so much in macroeconomics depend on how one deals with a concept like expectations, for which there is (inevitably?) so little empirical understanding and so much room for invention.20 If you know where to look, though, you will find a growing body of new work that displays an impressive empirical understanding of aggregate expectations, so its lack is in no way inevitable if we put our minds to it.
As Solow intimates, a solid concept of expectations is crucial. We may be close to that goal. Certainly if stock markets are patterned, so must be the causal forces driving them. Citing the prior work of Paul Montgomery of Universal Economics and Paul MacLean of the National Institute of Mental Health, Prechter presents an intriguing hypothesis regarding the forces behind expectations. He proposes that this key macroeconomic variable may derive from pre-rational thought patterns that drive the fundamental impulse of human social cooperation in a context of uncertainty.21 The emotions that govern expectations, he says, are essentially a “first cause,” generated by impulsive portions of the brain associated with herding. Yale economics professor Robert J. Shiller, a leading voice in the new field of behavioral finance, concurs at least to the extent of saying, “Solid psychological research does show that there are patterns of human behavior that suggest anchors for the market that would not be expected if markets worked entirely rationally.”22 If so, consider an alternative to mainstream macroeconomics’ idea that each individual is a “representative agent” with rational expectations, responding mechanically to exogenous changes in news about economic fundamentals to create in the aggregate a random walk in the stock market and the economy. Perhaps we should entertain the contrasting assumption that endogenous changes in aggregate expectations—in confidence and mood, in optimism and pessimism—are at least a force, if not the driving force, behind stock prices and the economy.23 The economy expands and contracts not because of random shocks, as suggested by mainstream business-cycle theory, but because optimism and pessimism in societies naturally trend and reverse in the form of a robust fractal.
With this new insight, we may begin to suggest a consistent theory of business cycles: Naturally expanding optimism during a boom stimulates hiring, expansion, investment and speculation. Euphoria in the latter stages encourages excessive credit extension and cavalier financial risk-taking. When optimism reaches a natural extremity, the boom ends and pessimism takes over. Companies lay off employees, investors recall their capital, lenders recall loans, banks tighten credit, bankruptcies accelerate and a major contraction ensues. When pessimism has run its course, debt has been liquidated to low levels, financing has become conservative, the stock market has reached its nadir, the society is ready for recovery.24 There are no “new eras” or “new economies” and no conditions upon which the patterns of social behavior will disappear.
The indication that a major change is actually beginning comes with a major trend change in the stock market, which is a proxy for a major change in expectations. The model has some predictive value because the necessary precursors for a major change in trend are a state of extremity in the volume of debt and a potentially completed wave pattern of changes in expectations at high degree.
Recall the sweeping certainty of the quotation that begins this article, the guarantee in 1997 of “Asia’s Bright Future” and the Harvard Economic Society’s assertion in 1929 that “a severe depression such as 1920-21 isoutside the range of probability” and will not happen. As it happens, our new model also explains why conventional macroeconomists are so certain just before they are most wrong. Because economists lack useful tools to guide them, they are powerless to resist getting caught up along with everyone else in the optimism at the peak or the pessimism at the bottom. Or, as Prechter asserts, “the prevailing social mood has full rein to affect the tone of their conclusions.25
Nobel laureate James Buchanan, in his “Economics and Its Scientific Neighbors,” stated, “Precisely because it has divorced itself from the central proposition relating to human behavior, [Keynesian and Post-Keynesian] macroeconomic theory is really no theory at all.”26 In contrast, the new model provides a consistent theoretical framework with strong predictive implications. For the linear extrapolation of the present commonly used by macroeconomists, it substitutes the nonlinear framework of markets’ robust fractal patterns. This framework, in turn, offers compelling evidence that, to a first degree, changes in optimism and pessimism, measured by changes in stock market indices, are independent of changes in economic variables, which simply follow. By understanding the nature and hierarchy of stock market changes, we economists can improve our predictions for the economy in terms of form, magnitude and timing.■
1 Dornbusch, Rudi. (1998, July 30). “Growth forever.” The Wall Street Journal.
2 Based on nominal figures provided by Irving Fisher’s son and biographer, Irving Norton Fisher, and adjusted by the U.S. CPI.
3 Ibid. Figures provided by Keynes’ biographer, Professor Skidelski.
4 Grabbe, J. Orlin. (n.d.). “And Now, Financial Apocalypse.” www.aci.net/kalliste/Apocalyp.htm.
5 See endnote 1.
6 “Something Unexpected Happened.” (2000, Dec.). The Region. Minneapolis Fed.
7 Lucas, Robert. (1977). “Understanding Business Cycles.” In K. Brunner and A. H. Meltzer, (Eds.) Stabilization of the Domestic and International Economy. North Holland, p. 15.
8 Elliott, Ralph N. (1938). The Wave Principle. Reprinted in Robert R. Prechter, Jr. (Ed.) R.N. Elliott’s Masterworks. Gainesville, GA : New Classics Library, 1980/1994.
9 Arneodo, A. et al. (1993). “Fibonacci Sequences in Diffusion-Limited Aggregation. In J.M. Garca-Ruiz et al. (Eds.) Growth Patterns in Physical Sciences and Biology, New York, Plenum Press.
10 Discrete scale invariance, as developed in: D. Sornette (1997, October 15). “Generic mechanisms for hierarchies.” InterJournal Complex Systems, 127. And (1999). “Discrete Scale Invariance and Complex Dimensions.” Physics Reports, 297.
11 Prechter, Robert R. (1999). The Wave Principle of Human social Behavior. And (1995). At the Crest of the Tidal Wave. And with Frost, A.J. (1978). Elliott Wave Principle.
12 Arneodo et al. put it this way: “There is room for quasi-fractals between the well-ordered fractal hierarchy of snowflakes and the disordered structure of chaotic or random aggregates.”
13 Prechter, Robert R., email in response to inquiry.
14 Sornette, Didier and Anders Johansen. (1997). “Large Financial Crashes.” Physics A, 245, 3-4.
15 Prechter, Robert R. (1999). The Wave Principle of Human Social Behavior.
16 Lo, Andrew W. and MacKinliy, A. Craig. (1999). A Non-Random Walk Down Wall Street. Princeton University Press.
17 Bateson, Gregory. (1972). “Form, Substance and Difference.” Steps to an Ecology of Mind. Chandler , p. 449. Also Collingwood, R.G. (1945). The Idea of Nature.
18 Hayek in February 1929 wrote in the Austrian Institute of Economic Research Report, “The boom will collapse within the next few months.” Mises foresaw a worldwide depression in the 1930s, as reported by Fritz Machlup, Mises assistant at the time. Mises’ wife, Margit, wrote in her husband’s biography that, in the summer of 1929, he declined a high-ranking position in Kredit Anstalt, then one of the largest banks in Europe because “a great crash is coming and I do not want my name in any way connected with it.” Within two years, Kredit Anstalt was bankrupt.
19 Keynes’ opus magnum, The General Theory of Employment, Interest and Money, contains not one but several theories. The profession, unfortunately, adopted the Hicks-Samuelson version.
20 Solow, R. (2000, Winter). “Toward a Macroeconomics of the Medium Run.” Journal of Economic Perspectives.
21 See endnote 15.
22 Shiller, Robert J. (2000). Irrational Exuberance. Princeton University Press.
23 Early in the century, some economists were well aware of the importance of these waves of optimism and pessimism. See Pigou, Arthur C. (1927). Industrial Fluctuations. Also (1920). The Economics of Welfare. And, yes, Keynes, John Maynard. (1936). The General Theory of Employment, Interest and Money.
24 An expanded treatment of this process applied to the present situation appears in Douglas, H. Cortes. (2001, January). “Forewarnings.” Catholic University of Chile.
25 See endnote 15.
26 Buchanan, James, (1979). What Should Economists Do? Liberty Press.
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