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The Daily Capitalist: Bernanke Makes a Stunning Admission

According to the Fed chairman, he now believes the "science" of econometrics is as fleeting as its results

Fed chairman Ben Bernanke gave a startling commencement address for the Boston College School of Law Class of 2009 last week. He admitted an apparent turnabout of his fundamental views of economics. No news media picked up the significance of what he was saying.

After the introductory and self-humbling remarks usually made by great men at these events, he made the following revelatory comment:

“Instead, I’d like to offer a few thoughts today about the inherent unpredictability of our individual lives and how one might go about dealing with that reality. As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy.

“The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming.

“Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.” (Emphasis added)

Let me translate this for you on two levels. On one level Bernanke is talking about his personal belief in the failure of economic prediction, and at another level, is the realization by him of the failure of the science of econometrics. No small thing.

Here’s what he says in a nutshell:

» He has spent his life trying to predict economic behavior.

» The tools used to predict the future have not been very successful.

» The science of economic prediction cannot be based on mechanistic models suitable to measuring physical matter.

» Our knowledge of human behavior will always be imperfect.

» Therefore, human behavior is very, very difficult to predict.

This is a humble and revealing statement from a man who believed the Fed could prevent a depression by carefully applying the monetary tools of the Fed. Bernanke, a student of the Great Depression, gave a speech in 2002 at Milton Friedman’s 90th birthday in honor of Friedman’s work on the monetary causes of the Depression. Friedman had claimed to trace the “cause” of the Depression to the Fed’s contraction of the money supply. Bernanke said in his address:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna (Schwartz, co-author of A Monetary History of the US): Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Here is the shocking thing about what Bernanke is saying now: he has apparently adopted the methodology of the Austrian School of economics which is radically different from the methodologies of the Keynesian and monetary schools of economics which dominate academia.

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Basic Keynesian Formula

The mathematical econometrics used by the Keynesians and Monetarists attempt to predict human action as one would measure and predict the behavior of physical matter. These mathematical models operate similarly to what physicists would use when they try to describe and predict the behavior of an atom of oxygen under certain obviously repeatable behaviors (i.e., the laws of physics).

But as Bernanke points out, it doesn’t really work that well. The Austrians figured this out in the 1920s. Economists like Ludwig von Mises and Friedrich von Hayek established a completely different way of looking at economics and rejected attempts to turn the social sciences into a hard science like physics. Here’s how Hayek put when he received the Nobel Prize in economics in 1974:

“It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences — an attempt which in our field may lead to outright error. It is an approach which has come to be described as the ‘scientistic’ attitude — an attitude which, as I defined it some 30 years ago, ‘is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.’”

What the Austrians said was that human society is too vast and complex for any accurate measurement, that you can never quantify the everyday decisions of millions of actors in the economy, and you never can know if you’ve picked the right data to measure. Hayek noted that:

“We know: of course, with regard to the market and similar social structures, (there are) a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. 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.”

The “science” of econometrics is what is taught at every major university econ department. It is required for an advanced degree, especially at Harvard and MIT. The Austrians say this is all nonsense and it has never been reliable, and it is frequently wrong. Going further, it is dangerous because it has been used as a blind tool of social engineering by governments to control the behavior of their citizens.

Bernanke seems now to admit this fact.

Folks, this is huge. If the Fed believes it cannot accurately predict the results of the impact of monetary policy on the economy, as Bernanke admits, then what good is monetary stimulus or any other policy they take? How, under their own standards, can they determine how to set interest rates without accurate econometric measurements? How do they know if Keynesian fiscal stimulus will work without econometric measurements?

The quick answer is that these policies don’t work, have never worked, and they cause problems rather than solutions. If we look closely at this issue, their failures might help explain why we have had one boom-bust cycle after another.

For generations, Keynesians have made apology after apology for the failure of the mathematical formulas developed by Keynes and the neo-Keynesians to control economic behavior. The apologies are always the same: they didn’t do it soon enough, they didn’t spend enough, the wrong types of stimulus were used, etc., etc. Enough!

Bernanke was shaken to his core because everything he assumed about the economy and econometric analysis failed him in the current economic crash and depression. Things spun out of control in a hurry and the Fed and the Treasury panicked and resorted to every trick in the Keynesian and monetarist book to stop the carnage. For the most part, what they have tried has not worked. But what they have done is set the stage for huge problems in the future — high inflation, high taxes, and more government control over an already sluggish economy.

My hope is that Bernanke will rethink his policies and change the direction of the Fed away from inflation and debt.

Econometrics is a false science. There are far superior ways of getting at the truth of economic behavior and my hope is that Bernanke will now take the next step and explore the ideas behind his revelation. If he does, he will save us all.

— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.

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