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Economic Forecasting: How Good Is It?

Henry Hazlitt

Henry Hazlitt, a frequent contributor to The Freeman, has a long and distinguished career as an economist, journalist, editor, and literary critic. Best known of his numerous books is Economics in One Lesson, originally published in 1946 and translated into ten languages with sales of more than 700,000 copies. The recently revised edition is once more available in inexpensive paperback.

A professor of one of the physical sciences at a large university recently wrote me to ask whether “scientific” prediction, precise and certain, is possible in economics. My reply follows:

The answer is No. And from the very nature of the science it never will be.

The main purpose of economics is not to predict the future, but to learn what policies are likely to improve that future. Sound economists already know a good deal about those policies, and have known much of it ever since the appearance of Adam Smith’s Wealth of Nations in 1776. The best policies for a country are to maintain a sound currency system (which historically has meant the gold standard), to keep the politicians from inflating and printing inconvertible paper money, and to keep the government from interfering in the economy except to prevent violence, theft and fraud.

Yet we are all individually obliged, in every action we take—whether choosing a career, applying for a job, marrying, having children, buying a house, buying a car, making an in- vestment—to speculate on the future. And the more informed and sensible we are, the better our guesses are likely to be. But we must resign ourselves to living in a world of uncertainty. We can never eliminate the gambling element, the element of sheer chance.

Economics is a science, but it is a science with its own special nature, purposes, and methods. It is a common error to dismiss it as a pseudoscience because it does not employ the same methods or produce the same results as the physical sciences. The physical sciences have been built up partly by deductive reasoning, but mainly by observation, by induction and statistics, and by actual experiment. Economics has been built up mainly by deductive reasoning, though of course it requires observation and detailed knowledge of business processes and of what people do to make a living. Isolable economic experiments, in any scientific sense, are impossible and unnecessary. Economics is the study of human action and human choice.

The Possibility of Dependable Prediction

Let us come now to the possibility of dependable prediction. Such prediction is usually most explicitly made in the choice of an investment. The future of the stock market, and attempts to predict it, make an ideal microcosm for study.

The prices on today’s New York Stock Exchange represent the composite estimates of millions of stockholders all over the world concerning the individual values of the more than 2,000 issues listed there. These estimates do not necessarily reflect the most recent reported earnings of the corporations concerned, but the assumptions and individual fragments of knowledge of the millions of different stockholders, and above all their composite expectations regarding the future of these corporations.

(As to the number of people involved daily in the stock market, there are more than 30 million holders of American stocks, the daily transactions on the New York Stock Exchange averaged 65,000,000 shares in 1982, and the average transaction was 1,306 shares. So on the assumption of at least two persons involved in each transaction—a buyer and a seller—there were some 100,000 persons in the market each day. Of course this figure is something of a stab in the dark, because one broker may on the one hand make a transaction in the name of a bank, a brokerage firm or a mutual fund as well as of an individual, and on the other hand an individual broker may make more than one transaction.)

Putting aside such events as investing new income, and such contingencies as forced sales, to sell is in effect to bet that a stock is selling higher than it will be in the future, and to buy is to bet that a stock is now selling lower than it will be in the future (at least as compared with other stocks). Each of us, when he buys or sells stock, is in effect betting his own knowledge and judgment against the composite knowledge and judgment of millions of other stockholders.

So instead of all of us agreeing on one scientific prediction about the future, probably no two of us precisely agree about it. Stock prices fluctuate every hour of every day, because the knowledge of each of us is limited and the unexpected is always happening—we live in a world of daily surprises. Some investors and speculators can do better than others, because they are wiser or luckier, but nobody can have a perfect record. Not even the best professional forecaster.

Let us remind ourselves that the economic future itself is only a part, and an inextricable part, of the total future of all of us. To ask anyone to predict that economic future exactly is to ask him to predict the total future.

Conditions Constantly Changing

“Scientific” economic prediction would only be possible in the purely hypothetical situation that economists of a past generation called “the stationary state,” that most of them now call “equilibrium,” and some “the evenly-rotating economy.” As a tool of thought, this hypothetical assumption can be often useful; but the condition itself never in fact exists. It would be a state in which nothing unexpected ever happened—no erupting volcanoes, no earthquakes, no tornadoes, no floods, no droughts, no revolutions, no sudden outbreaks of war, but also no progress, no discoveries, no major advances in technical knowledge, no inventions. The future could be predicted, because there would be no changes to predict-no decline, no growth, no recession, no boom. Every industry would retain the same size relative to every other. And so ad infinitum.

But in the fluctuating, capricious, erratic and dynamic economy in which we actually live, the factors to be put into a possible predictive formula or equation are practically without limit. We don’t know what relative weights to give each of them, and we don’t even know what some of the factors are. We are not even dealing, as so many so-called economists unfortunately imagine, with measurable objective quantities, but mainly with subjective elements, with expectations, with wavering values. And we can only measure these at any given moment comparatively, not absolutely. An automobile exchanges today for so many dollars and cents, but tomorrow either the value of the car or the value of the dollar may be different.

(This points to the fallacious and misleading nature of so many government statistics—the “national income,” for example. A short crop of wheat or corn usually sells for a greater dollar total than a bumper crop, so a short crop can make the national income go up. If everybody once had as much of everything as he wanted, the national income would be zero, because nothing could command a price.)

Yet, to repeat, we are all unavoidably speculators. We are all obliged to make our own forecasts once in a while. And in making them there are a few factors we must keep in mind.

One of them is that our predictions must commonly be based on what we expect other people to do. When we attempt, in this inflationary era, to predict the future rate of inflation (which is crucial in every economic decision), we must keep in mind the recent history of Congressional spending and deficits, as well as what appears to be the complete absence of any sense of fiscal responsibility on the part of most of the members of Congress. If we do keep this in mind, we will certainly expect a higher rate of inflation both in the next few months and the next few years than is currently being estimated by any of the government economists. Such considerations won’t enable us to say precisely what the rate of inflation will be in any given month or year, or how long it will continue at that rate, but they will make our guesses better than otherwise.

Another factor to be kept in mind (and one which certainly does not apply in predictions of purely physical or chemical changes) is that our expectations of the economic future themselves act to change that future. Let us suppose that a very wealthy man, call him John Smith, decides that a certain stock, say that of the Widget Company, is probably going to go up some 30 points in the next thirty weeks. He starts buying; and if his resources and faith are strong enough, he may bid up his final purchases almost the full 30 points today.

To sum up: No professional forecaster can always be right, but some, with superior knowledge and expert analysis, can be right more often than others. With the future so uncertain, each of us, every investor and every businessman, is compelled to be a speculator. But fortunately, it is not necessary that any of us turn out to be always right. As Ludwig von Mises has pointed out: “It is not correct foresight as such that yields profits, but foresight better than that of the rest.”

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