Wednesday, August 22, 2012

The Failure of Macro

Mama always told me not to look into the eyes of the sun

 But mama, that's where the fun is

Blinded by the Light, by Manfred Mann's Earth Band

Friedrich Hayek’s lecture given at the ceremony of his being awarded the Nobel Prize in Economics is entitled “The Pretense of Knowledge.”  In this lecture, given on this occasion celebrating the highest achievements of the economics profession and in the presence of many of the highest achievers in the profession, Hayek explains the fallacy of the grandest of the grand: macro-economics.  Basically, he is condemning most of his audience.

So-called macro-economics is the field that pretends to analyze and understand via mathematical formulas and equations the movements across an entire economy – meaning across the actions of countless millions if not billions of actors.  Macro-economists then proceed to offer policy advice to government actors – call it central planning, as there is no other term that can be applied.

This as opposed to micro-economics, the field of studying individual actors and actions – a more humble field, recognizing action takes place at the individual level, between and among acting individuals.  Some call it Human Action (hey, someone should write this book). 

Which field offers the economist more power and recognition?  Which one offers the politician more legitimacy?  Which field is where the fun is?  (Hint: think Bernanke) But as you might guess from the title of Hayek’s lecture, which field is justifiably due for his criticism?

Hayek begins the lecture by throwing a stomach punch at his audience:

…the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue.  We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

Immediately Hayek identifies that it is the economists making policy recommendations that governments willingly and eagerly pursued.  Alas, the result has been failure – at least for the cause of an improving economy (assuming this was the objective).  The lecture was given in 1974, at a time of accelerating inflation.  Recall, this was only a few years after the global monetary system was unshackled from the discipline of gold (and at that, a faulty discipline based on the centrally-planned economic system of Bretton Woods), albeit the U.S. was playing fast and loose with the system for years before this.

Hayek then points out that the failure is grounded in the attempt to mimic analysis in the model of the physical sciences, with known, observable, and quantifiable inputs; with the possibility of experimentation, all else equal.  Hayek suggests that no such thing is possible when speaking of the future actions of countless individual actors.  One cannot know all of the factors in the decision making of each actor, nor can one expect these factors to remain constant over time.  Worse, while it is certain one cannot capture all of the data, it is also highly likely that one is not even capturing the important data:

This brings me to the crucial issue.  Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones.  While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable.

In the social sciences, it often is the case that what is measureable ends up being deemed what is important – regardless of the reality.  Yet, much that is important in social sciences is immeasurable: no one knows a man’s mind, and even the acting man may not know his mind a day or a year from now in a new and different circumstance.

And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

Hayek speaks specifically to the point of prices and wages, and to the impossibility of understanding these via mathematical calculation and modeling:

…there will enter the effects of particular information possessed by every one of the participants in the market process—a sum of facts which in their totality cannot be known to the scientific observer, or to any other single brain.

Even if that brain is the most powerful super-computer.  The issue is not one solvable with ever-higher computing power.  Economists cannot capture the variables.  This is not a calculation issue; no calculation is possible if the variables cannot be captured, measured, and tested.

This was known even to the founders of mathematical economics:

…as Vilfredo Pareto, one of the founders of this theory, clearly stated, its purpose cannot be “to arrive at a numerical calculation of prices,” because, as he said, it would be “absurd” to assume that we could ascertain all the data.

Even the Spanish Scholastics understood the absurdity, bordering on blasphemy:

Indeed, the chief point was already seen by those remarkable anticipators of modern economics, the Spanish schoolmen of the sixteenth century, who emphasized that what they called pretium mathematicum, the mathematical price, depended on so many particular circumstances that it could never be known to man but was known only to God.

But playing god is fun, mama.

Hayek also does not accept that the flaws in mathematical economics are due to the field being relatively young:

Nor am I prepared to accept the excuse that this branch of research is still very young: Sir William Petty, the founder of econometrics, was after all a somewhat senior colleague of Sir Isaac Newton in the Royal Society!

He then points to another point of pretense: that of centrally managing the money supply.  This attempt at managing aggregate demand via monetary manipulations has resulted in a tremendous misallocation of resources, and must be continuously supported by ever increasing monetary injections – causing even further misallocations.

Hayek makes a very interesting observation about why there is such a focus on the macro-economy.  He does not suggest the power afforded to economists and the legitimacy given to government actors who desire to control (that would have been a real hoot in such a forum), however he makes a different observation:

It sometimes almost seems as if the techniques of science were more easily learnt than the thinking that shows us what the problems are and how to approach them.

On one level, I can agree with Hayek on this point.  It is easier to teach mathematical formulas, just as it is easier to grade the results on tests.  It is very objective and quantitative.  However, it strikes me how easy and straightforward Austrian economics is to learn and understand.  The one thing this school does not offer is power to the economists and control to the central planners.  These reasons strike me as much more important to the rise of macro-economics than the fact that the teaching is easier.

Hayek introduces the example of a ball game, understanding the variables and predicting outcomes.  It caused me to consider – how much time, money, and effort is spent on predicting and wagering in sports.  Yet a ballgame – when compared to the complexity of an entire economy – is quite simple to understand.  There are rules to the game; there are individual players, team characteristics, matchups against the opposing team, weather, etc.  A handful of variables; a limited population of circumstances.  And only one possible outcome out of only two possibilities: a win or a loss (in some sports, a tie….)

Yet what is the long term success rate for even the best who wager on such an event?  Sixty percent?  Seventy percent?  And this in a field, unlike macro-economics – where the actor has his own money on the line.  Yet somehow the economist is able to identify and recommend the right policy prescriptions in a game that includes and significantly affects countless actors, actions, and variables – almost all of which are unknown to the economist.

We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based—a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed.

Pricing and corresponding profit and loss are the most wonderful creations made by man – not created by any individual men or small group of men, but man as in society as a whole.  There is no better system to ensure the most desired wants and needs are met, and that these are met most efficiently.  There is no possibility that this system can be replicated or improved upon by a chosen few – although the power gained by advocating this possibility is too tempting to both the economist and the politician.

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society—a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

Please read again this last paragraph, the conclusion of Hayek’s lecture.  Here, Hayek pulls no punches, imploring humility while damning those as tyrants and destroyers of civilization who pretend to know better than the society of millions of individual actors.

But to control all of society, no matter how tyrannical and destructive…that’s where the fun is.


  1. I just recommended this article and your blog to Robert Wenzel, that he might pick you up as a contributor.
    I posted as gpond on TDB. Rarely, I always looked for your comments on any given article, and certainly miss that feature.
    You should not remember me and probably do not. The closest we came together was when a certain professor from CA was lauding state sanctioned marriages, and I proposed a hypothetical. Suppose all governments cease granting marriage licenses. Would mankind go extinct? The professor-genius answered in the affirmative.. Which I found to be totally mind-blowing!!

    1. gpond, thank you for the kind comments.

      I remember you from DB and I remember this conversation with the CA professor. One of countless comments from him that were incomprehensible to me.

      Thank you for the recommendation to RW at EPJ. He kindly linked to one of my earlier articles, for which I thanked him.

    2. Heard back from Bob. He said:

      "Just went over to his site, good stuff. Thanks for bringing it to my attention."