Economists Won't Predict the Next Crash — Because They Can't
You get a lot of attention if you shout out things like “The stock market is about to collapse”, or “The US dollar crash is just around the corner”, or “The housing market slump is about to unfold”. But from the viewpoint of sound economics, making these kinds of predictions is quite impossible. Putting probabilities to certain outcomes – such as "I assign a probability of 30 per cent that the stock market collapses in 2018" – might be fashionable among forecasters, but it certainly does not do the trick or make things any better.
To be sure: One cannot, and should not, dismiss the idea that there might be people out there who have the ability to forecast events happening in the future correctly on a sustained basis. For instance, a successful entrepreneur belongs to this very group. He or she comes up with products people want to buy going forward, and they sell these products at prices which exceed production costs. They are also in a position to forecast changes in consumer demand and adjust their output accordingly.
Also, there are successful stock market investors, who stand out with many years of outperformance compared to their competitors. To be consistently better than the market, they must see and know something others do not see or know, and take action accordingly. For instance, they must detect undervalued stocks, and reap a decent profit when the market pushes stock prices towards their intrinsic value. They successfully invest at the right time in the "right" shares, which deliver outperformance over time.
Successful entrepreneurs and investors must have what it takes – the vision, courage, business acumen, or whatever it might be – to get the future right. That does not mean that they will not make forecast errors. But for some reason, their forecast errors turn out to be less devastating than those of the majority of the people. One thing is certain, though: Successful entrepreneurs and investors do not base their forecasts on the idea that economics would put you in a position to make correct predictions. Why is this so?
Economics is not a science that provides you with the means for forecasting the future. As Ludwig von Mises puts it: “This is not to say that future human actions are utterly unpredictable. They can, in a certain way, be anticipated to some extent. But the methods applied in such anticipations, and their scope, are logically and epistemologically entirely different from those applied in anticipating natural events, and from their scope.1 Mises' statement might require some further explanation.
Rightly understood, economics is the science of human action, or, to be more precise, economics is about the logic of human action. Its “Archimedean Point” is the irrefutably true statement that “humans act”. The latter cannot be denied without causing a logical contradiction. If you argue “humans cannot act”, you act, and you would thus contradict your own statement. From the self-evidently true statement “humans act” we can deduce, or unfold, further true statements.
To give some examples: Human action, which is always the action of an individual, is purposeful; action requires means to attain goals; means are scarce; human action presupposes the category of means and ends, that is causality; time is an indispensable means for action; human action implies time preference and thus the originary interest rate (and both are positive, they cannot be zero, let alone be negative); the law of marginal utility is also logically implied in the statement “humans act”.
These (and other) statements are logically implied in the proposition that "humans act". Any economic theory that contradicts the implications of the concept of human action must raise serious doubts as to its truth value. For instance, an economic theory in which human action does not take time, or in which human action is not constrained by definite time preference and a positive originary interest rate, can be dismissed as being logically false (as unrealistic, as unworldly madness).
The Role of Ideas
The irrefutably true knowledge that humans act implies that ideas (or theories) make humans act. And ideas are the ultimate given in the explanation of human action; they cannot be traced further back to other explanatory factors. This we cannot deny.2 Denying it would assume the existence of external (physiological, biological, chemical) factors which systematically explain human actions. However, science has so far failed to come up with a definite relation between external factors and human action.
In fact, there is a logical reason why such a relation cannot be discovered: Man undeniably has learning ability, meaning he can learn.3 Arguing “Man cannot learn” presupposes that man can learn; otherwise one wouldn’t say anything to someone else; assuming the contrary would amount to a performative contradiction. And arguing that “Man can learn not to learn” runs into an outright logical contradiction. As we cannot reject the notion that humans have learning ability, we can understand why we cannot know the future of our actions.
For if we assume that we know today how humans will act in the future, we would say that we have not only sufficient knowledge about natural phenomena but also know humans’ future choices, preferences and value scales in the future. The latter, however, would imply the denial of learning ability: Knowing today how humans act in the future would contradict the logically true statement that humans have learning ability – for we would know today all things happening in the future – but this is a logical contradiction and thus false.
It is now easy to also understand why there cannot be any constant relation between external factors and human action – in the sense that if the factor X occurs, humans will take certain action, and the result will always be Y. From experience, we know that different people, in response to given stimuli, often act differently at different points in time. But experience does not prove anything. Luckily, we do not have to take recourse to experience to know that there are no quantitative regularities in human action.
The reason why there are no such behavior constants is a logical one: If the external factor X causes certain action (in the sense of “if X, then Y”, or “if X goes up by 10 per cent, then Y will decline by 5 per cent”), we would be in a position to forecast today human action in the future (in quantitative terms) – and again, we would thereby contradict the logical conclusion that humans have learning ability: If we know today how we will act in the future, we have to assume that we cannot, and do not, learn along the way.
Now we have come full circle. Economics – if and when rightfully understood as the logic of human action – does not, and cannot, provide you with insights predicting future human action. Any attempt to use economics for making predictions runs counter to logic and is thus bound to fail. This by no means suggests that economics is a trivial undertaking. On the contrary! What economics can do is outline (with absolute certainty) the qualitative results of human action taking place under certain conditions and circumstances.
For instance, economics tells you with apodictic certainty that if people engage in voluntary exchange, all parties will benefit; or if the central bank increases the quantity of money, the purchasing power of the money unit declines (compared with a scenario in which the quantity of money had remained unchanged); or that a rise in the quantity of money in the economy will never be “neutral” as far as peoples’ income and wealth positions are concerned, it will always benefit some at the expense of others.
The vast majority of economists these days is, however, heavily engaged in the business of forecasting. They try to forecast where, say, interest rates, stock prices, exchange rates will stand in 3, 6, 12 months, or even farther out. And there is demand for such forecasts: A great number of investors is eager to listen what these forecasting economists have to say about the future, and quite a few investors take the economists’ forecasts seriously, namely as input for their investment decisions.
From what we have outlined earlier, however, we can know for sure that “mainstream” economists will fail in the effort to forecast the future and that a significant number of investors will get disappointed: Economics as a science cannot predict how humans will act, it cannot quantitatively forecast how economic magnitudes will develop. Such predictions are, and for logical reasons, beyond the reach of economics. One should not be misled about this fact by elaborated mathematical models and highly sophisticated econometric techniques.
The truth is that any economist who thinks that the science of economics is about forecasting is disoriented. His or her advice will not help you make wise investment decisions. So what should you do if you are concerned about a looming stock market crash? The answer is pretty straightforward. If you think you cannot be better than rest of the pack, invest in a broadly defined stock market index (or certificate) and stick to it. Because if you cannot outperform, there is simply no point in engaging in any crash forecasting.
Alternatively, you could turn to consistently successful entrepreneurs and investors for seeking advice. Perhaps they would tell you not to waste any time on forecasting a stock market crash – for no one knows how people will react in the future. Successful businesspeople and investors might come up with a rather different recommendation: namely, put your money in great businesses, purchased at a decent price, and stick to it, whatever may come. Over time, you will be doing better than those thinking they could forecast the crash.
Be that as it may, economics teaches us about the laws of human action, but it does not provide insights about how people will behave in the future, how human beings will quantitatively respond to certain factors. Economics is not a forecasting science, it is a reconstructing science: It allows us to understand, from the starting point of the irrefutably true statement that humans act, the qualitative consequences if humans act under certain conditions which, however, are often uncertain from the present point of view.
Murray N. Rothbard credits this solid, logically grounded and, as far as practical matters are concerned, most crucial insight to Ludwig von Mises: “It is above all Ludwig von Mises who recognizes the freedom, of mind and choice, at the irreducible heart of the human condition, and who realizes therefore that the scientific urge to determinism and complete predictability is a search for the impossible—and is therefore profoundly unscientific.”4
- 1. Mises (1957), Theory and History, p. 5.
- 2. For an explanation see Mises, L. v. (1962), The Ultimate Foundation of Economic Science, pp. 53 – 55.
- 3. See Hoppe, H.-H. (1983), Kritik der kausalwissenschaftlichen Sozialforschung, pp. 15 – 16, 17 – 18.
- 4. Rothbard, M. N. (1957), Preface to Theory and History, p. xvii.