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History
does not repeat itself...but it rhymes —Mark Twain
"This
expansion will run forever." Not two years, or three, or ten.
Forever. That was how an MIT Professor of Economics summarized his
vision of the U.S. economic expansion in the July 30th, 1998 issue of
the Wall Street Journal.
Nowadays
his assertion appears extreme. It did not then. This exuberance was
rationalized by the obvious fact this was a New Economy with no room for
recessions. Dornbusch himself said the American economy would "not
see a recession for years to come"? Mmmm, why? Because, Dornbusch
again, "We don't want one, we don't need one, and, as we have the
tools to keep the current expansion going, we won't have one."
"We", apparently, are the macroeconomists.
More
Dornbusch: "Only natural causes, and not the Fed, can bring the
economy to a standstill. Fortunately, we have the monetary and fiscal
resources to keep that from happening, as well as a policy team that
won't hesitate to use them for continued expansion."
In
the latter part of the 1990s, euphoria was rampant and not only in the
States. "It is hard to imagine any article with worse timing than,
say, 'Asia's Bright Future,' by Harvard Professors Steven Radelet &
Jeffrey Sachs, writing in the November/December 1997 issue of Foreign
Affairs". So J. Orlin Grabbe told us. Their article was
published at the precise moment East Asian financial markets and
economies were deepening their collapses. As Grabbe put it: "Of
course Asia probably does have a bright future, much as Europe
could have been said to have had a bright future during the Black Death
years of the 14th Century."[1]
It
is one thing to say crises are undesirable, but another to say
macroeconomists are, firstly, so skilled at forecasting they can predict
trend breaks to the downside; and secondly, they have the tools and the
policy teams to avoid economic and financial crises. If this were so,
why do they utterly fail over and over again at forecasting economic
downturns? Why do they have to adjust their projections over and over in
times of trend change? Why has Japan stagnated for 11 years and had
three recessions during that time?
The
dismal record of forecasting crashes and recessions we economists have
is not new. The crash of 1929 and the Great Depression came as an
unexpected avalanche to economists, particularly those in the hall of
fame.
Fourteen
days before Wall Street crashed on Black Tuesday, October 29, 1929,
Irving Fisher, America's most famous economist, Professor of Economics
at Yale University, said: "In a few months I expect to see the
stock market much higher than today".
Days
after the crash, the Harvard Economic Society informed its subscribers:
"A severe depression such as 1920-21 is outside the range of
probability. We are not facing a protracted liquidation." After
continuously issuing erroneously optimistic forecasts, the Society
closed its doors in 1932. The two most renowned economic forecasting
institutes in America at the time failed to understand that a crash and
depression were forthcoming, and continued their optimism even as the
Great Depression swept over America.
Irving
Fisher lost 140 million U.S. dollars[2] in the stock market crash.
Fisher was a man of many talents, a great economist, excellent
theoretician, one of the founders of econometrics and pioneer in index
number analysis. He was also the inventor of the c-kardex file system
which he sold to Remington Rand for millions, which he subsequently lost
in the crash.
John
Maynard Keynes, the most famous British economist and the father of
macroeconomics, who made fortunes in the financial markets for himself
and Cambridge University, lost one million English pounds[3] in the
crash.
With
two exceptions, no academic economists forecasted the crash of 1929 and
the following depression.
Seven
decades have gone by. Surely we must know more today? In 1988, sixty
years after the crash and the depression, Kathryn Domínguez, Ray Fair
and Matthew Shapiro concluded in the American Economic Review,
the leading journal of the American Economic Association, that employing
sophisticated econometric techniques of the late nineteen-eighties and
even using data unavailable in 1929, the Great Depression could not have
been forecasted.
In
October 2000, sixty economists gathered at the Minneapolis Fed to
present papers and discuss the Great Depression of the 1930s. The cream
of the macroeconomic profession was present: Nobel prize-winner Robert
Lucas, Ed Prescott, Tom Sargent, Ben Bernanke, Finn Kydland, Nancy
Stokey, Kevin Murphy and many others. The gist of the conclusions may be
found in the headline that the Minneapolis Fed's review The Region
used for the conference's article: "Something Unanticipated
Happened". "In his summary remarks at the close of the
conference, Robert Lucas made a pitch for the continuing investigation
of macro fundamentals. . . . 'We should continue to seek common
factors,' he said, and offered monetary instability as one area for
further exploration. Big deflations are related to depressions, he said,
and everywhere in the 1930s there was deflation."[4]
The
concluding paragraph of the article states: "In the end, if the
Great Depression is, indeed, a story, it has all the trappings of a
mystery that is loaded with suspects and difficult to solve, even when
we know the ending; the kind we read again and again, and each time come
up with another explanation. At least for now."[5]
Economists,
especially since 1936, and as Bob Lucas' quote reveals, look at
macroeconomic fundamentals. Yet history teaches us no financial collapse
has ever happened when things look bad. On the contrary, macroeconomic
flows look good before crashes. Before every collapse, economists find
the economy in excellent shape. In a major boom, the economy is a
"New Economy". As President Hoover tells us in his Memoirs
about the period preceding the Great Depression: "With increasing
optimism, they gave birth to a silly idea called the New Economic Era.
This notion spread all over the country. We were assured we were in a
new era where the old laws of economics no longer applied."[6] Too
familiar, perhaps.
In
these new eras, everything looks rosy, stock markets go up and up, and
macroeconomic flows (output, employment, etc.) appear to be improving.
Macroeconomic fundamentals, however, tell us about the past, and the
good times are invariably extrapolated linearly into the future.
Friedrich
von Hayek, 1974 Nobel Laureate, was the only academic economist who
wrote prior to the Great Depression that a crisis and downturn in
America were imminent. Interest rates in the world would not fall, he
wrote, until the American boom collapsed. And "the boom will
collapse within the next few months". This prediction, printed in
the Austrian Institute of Economic Research Report, February,
1929, generated interest in Austrian economics and Hayek was offered a
Professorship at the London School of Economics in the early 1930s.
Ludwig
von Mises, also an Austrian, anticipated 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 had rejected a high position in Kredit Anstalt, one of the
largest banks in Europe at the time. His explanation was "a great
crash is coming and I do not want my name in any way connected with
it". Less than two years later, Kredit Anstalt was bankrupt.
Did
rational economists adopt the economics of Hayek and Mises? Alas no,
they adopted the economics of Keynes.[7]
But
Hayek and Mises were exceptions. Not only did economists fail to
forecast the Great Depression of the 1930s, but they have also failed to
forecast economic contractions in general. The present contraction (in
2001) is only the latest example. "Economists have a dismal record
in predicting recession" is the subtitle of an article in the
November 29th, 2001, issue of The Economist.
Why
is this so? What is it that economists do not know? Or what truths did
they once know—ones since forgotten or neglected?
First,
the facts.
Three
centuries of financial crises and economic contractions yield four sets
of empirical observations.
1.
Money and Debt, Financial Markets and Business Cycles.
This
first set is consistent with postulates of Business Cycles Theories
well-known to economists but neglected nowadays. Sizable and sustained
increases in money and private sector debt accompany financial and
economic booms. Important contractions in money and private sector debt
accompany financial and economic contractions. This observation is
consistent with Monetary and Austrian (Ludwig von Mises and Friedrich von Hayek)
theories of the business cycle. Bob Lucas' remarks indicate a renewed
interest in these theories may be forthcoming.
Debt
accumulation speeds up during booms. Changes in the level of private
debt correlate with changes in stock markets indices and economic
activity, especially at higher degrees.[8] Debt increases heavily and
rapidly in times of financial and economic booms, and it decreases
importantly in times of major financial and economic contractions. This
observation on debt accumulation and deflation was highlighted by Irving
Fisher in his 1933 Econometrica article, "Debt-Deflation
Theory of Depressions", but it has received little attention since.
In a lifetime of work neglected by mainstream economics, Hyman Minsky
emphasized the financial instability created by mounting indebtedness
building up through time.
In
the high degree bull market which has just ended with the 20th Century,
debt accumulation in the private sector proceeded at a very fast pace
and reached very high levels, especially in the latter years of the
boom. However, little if any attention was paid by most economists to
this phenomena.
The
next two sets of observations, not considered by economists, are of
course the key to understanding economic contractions of all degrees.
Their not considering them is the explanation for economists'
dismal forecasting failures.
2.
Stock markets indices are patterned.
Stock
markets trend and reverse in recognizable patterns.[9] Structures are
clear and definite in form [not in time or amplitude]. Patterns of
smaller degree link together to form similar patterns at a larger
degree. These insights date to the careful inductive analysis published
in the 1930s by Ralph N. Elliott[10], and to the important and
breathtaking work Robert R. Prechter, Jr. has pursued over the last
three decades, applying and extending these principles to a wide variety
of phenomena.[11]
Markets,
in other words, are hierarchical. These insights have been rediscovered
by physicists studying financial markets. Markets' movements, like
earthquakes, have different degrees.[12][13] More importantly, markets
are fractals (robust fractals or quasi-fractals).[14] Markets proceed
relentlessly according to form. Elliott and Prechter are in good
company: Pythagoras stood for inquiry into pattern rather than inquiry
into substance.[15]
"The
mysterious changes in market psychology"[16] proceed according to
pattern. Stock markets are not random walks, as is still taught in many
top graduate business schools. Rather, their changes exhibit fractal
behavior.[17] Stock markets as complex systems show discrete levels or
scales in a global hierarchy.
Viewing
markets as dynamic, complex systems, Sornette and Johnson conclude
markets proceed unabatedly toward a crash, "the market anticipating
the crash in a subtle self-organized and cooperative fashion, releasing
precursory fingertips observable in stock market prices."[18]
There
is, therefore, an element of predictability in markets not despite, but
because of, their complexity.[19]
3.
Financial market changes precede changes in economic variables.
High
degree bull markets in stock indices precede economic booms of high
degree. Bull markets of lower degree precede economic
expansions of lower degree.
High
degree bear markets in stocks precede economic contractions of high
degree. Bear markets of lower degree precede economic
contractions of lower degree.
Changes
in stock market indices thus precede, not follow, changes in economic
fundamentals or news about them. Changes in stock market indices are a
leading indicator of changes in economic activity. This was, of course,
recognized by Wesley Mitchell and the National Bureau of Economic
Research eight decades ago. But failure in identifying markets'
different degrees has made Mitchell's insight less useful. Witness
Nobel Prizewinner Paul Samuelson' s famous (and wrong) quip[20], a
result of completely missing the hierarchical nature of stock markets.
Finally,
4.
Booms are followed by Contractions.
High
degree bull markets in stocks are followed by high degree bear markets
in stocks. Correspondingly, high degree booms in economic activity are
followed by high degree contractions in economic activity.
Milton
Friedman's "Plucking Model", where contractions are related to
succeeding expansions and unrelated to previous expansions, is not
consistent with this observation. The Austrian Theory of the Business
Cycle (Mises and Hayek), where the excesses of the prior booms are the
sources of the following bust, is consistent with this observation.
After
the facts, a story.
"Economic
reasoning will be of no value in cases of uncertainty". These are
Robert Lucas' words.[21] Mises, Knight and Hayek have taught us,
however, uncertainty is normal and pervasive in society.[22] Markets
deal with uncertainty, coordinating information and knowledge. In a
world of uncertainty expectations are a critical variable in most
decisions, particularly for investment decisions, financing (increasing
debt levels) and other financial and economic decisions.
Nobel
Laureate Robert Solow has recently said, "it is acutely
uncomfortable 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".[23]
To have a better grasp of a relevant concept of expectations and
confidence is therefore crucial. As Bob Prechter says, however, although
expectations may imply rationality they are usually the product of
rationalization.[24]
An
alternative assumption to the macroeconomists' "representative
agent" with rational expectations can be fruitfully substituted to
obtain a more coherent explanation of observed patterns. In a world of
uncertainty, changes in expectations (in confidence, rather, in moods)
are reflected more rapidly in changes in stock market prices. The latter
can thus be used as a proxy for changes in confidence. Changes in the
trend of stock market prices become useful as a barometer of optimism
and pessimism. As changes in optimistic or pessimistic expectations lead
most changes in financial and economic decisions, it is no surprise that
changes in stock market prices are useful as leading indicators of
changes in the state of the economy.
Changes
in stock market indices do not respond to, nor are they caused by,
exogenous changes in economic fundamentals or news about them; they are
not random walks. Changes in stock market prices reflect changes in
confidence, moves from optimism to pessimism and from pessimism to
optimism. They precede (rather than follow) changes in economic
fundamentals.
The
preceding sentences provide an explanation for why negative changes in
stock market indices — of a very high degree — anticipate economic
depressions. Negative changes of lesser degree, in turn, anticipate
economic recessions and milder downturns. Stock markets are thus led by
waves of optimism and pessimism.[25]
Optimism
during the boom leads to higher indebtedness. Increasing private sector
debt is an important manifestation of optimism and euphoria in the
latter part of the boom. Excessive debt leads to financial fragility in
banks, business enterprises, and individual households. As the boom ends
and pessimism replaces optimism, lenders recall loans, banks contract
credit, bankruptcies are stepped up and a major economic contraction
ensues. Fragility turns into insolvency.[26]
The
final leg of a stock market boom — as seen in the NASDAQ in the years
prior to 2000, or in the Dow prior to late 1929 — is correlated with a
high degree of indebtedness, and is correlated in turn with the severity
of the subsequent economic contraction.
If
this is correct, an ex-post explanation of a major economic contraction,
for example, would start with a dramatic and sustained fall in stock
price indices, a proxy for a major breakdown in confidence, a change
from extreme optimism to pessimism. The high levels of debt, accumulated
during the boom at a very fast pace in the later years, would be
responsible for generalized financial fragility all over the economy.
This is what we have now.
The
change to pessimism, announced by the trend change in the stock markets,
will trigger loan recalling, bankruptcies, unemployment and generalized
economic contraction. This is what is beginning now. Only when debt
reaches very low levels, as a consequence of bankruptcies or of
inflation, is the economy ready for recovery. This will be some years
into the future.
Economic
Science?
Now,
is this economics?
I
use here the two tests posed by Nobel Laureate James Buchanan in his
"Economics and its Scientific Neighbors" to answer that
question[27]:
1.
Does this theory provide the economist with an additional set of tools?
By understanding the nature and the hierarchy of stock market changes,
patterns of stock market price changes can be predicted in form and
sometimes in time. Also, the elucidation of the degree of change in
stock market prices allows a prediction to be made on the degree of the
subsequent economic contraction. Thus, not only can economic
contractions be anticipated, but also their degree. More clearly, a
trend break in stock markets can be predicted in form, and that in turn
precedes a trend break in economic activity. Timing on the other hand
can only sometimes be pinned down with precision.
The
linear extrapolation so commonly used by macroeconomists ("the
crudest form of technical analysis")[28] is substituted by a
non-linear framework — the Wave Principle — which allows prediction
of trend breaks of different degrees.
I
believe it provides the economist with an additional set of tools.
2.
Does this extend the application of the central principles of the
discipline?
There
is clearly no contradiction with the statement: "More of any good
will be chosen, the lower its price relative to other goods", a
central tenet of economics.
Under
uncertainty, however, dealing with future prices involves not actual but
expected prices, and expected prices are highly dependent on whether
confidence is high or low. As stock markets are patterned, their changes
are — to a first degree — exogenous to economic variables.[29] We
can state this as an assumption: To a first degree, changes in
optimism and pessimism, measured by changes in stock market indices, are
exogenous — independent of changes in economic variables (or
"macro fundamentals", as Bob Lucas called them).
As
stock markets are patterned, so are the true causal forces.[30] They are
not random. Stock market patterns are predictable in form and sometimes
predictable in time. The economy goes into an economic contraction not
because of random shocks, as stated by real-business-cycle theory, but
because extreme optimism, euphoria, is replaced by growing pessimism.
Is
this extending the application of the central principles of economics? I
am not sure.
Does
this theory have predictive implications? Most certainly. This indicates
it may become a science. But, again, is it economic science?
Most
likely not.
Footnotes
[1]
J. Orlin Grabbe, "And Now, the Financial Apocalypse",
orlingrabbe.com/Apocalyp.htm.
[2]
Calculated by the author on the basis of nominal figures provided by
Irving Fisher´s biographer son, Irving Norton Fisher.
[3]
Figures provided by Keynes´ biographer Professor Skidelski.
[4]
"Something Unanticipated Happened", The Region,
Minneapolis Fed, December 2000.
[5]
Ibid.
[6]
As I have lost the English text, and translated back into English from
Spanish, some words may be different in the original.
[7]
They did not however pay attention to key insights contained in Chapter
12 of Keynes' The General Theory.
[8]
Financial booms and contractions involve a hierarchy with different
degrees of change in financial markets, as earthquakes do.
[9]
As well as financial markets in general.
[10]
Ralph N. Elliott, The Wave Principle, 1938. Reprinted in Robert
R. Prechter, Jr., editor, R. N. Elliott's Masterworks, Elliott
Wave International. Also, Robert R. Prechter, Jr., editor, R. N.
Elliott's Market Letters, Elliott Wave International.
[11]
Robert R. Prechter, Jr., Wave Principle of Human Social Behavior,
1999; At the Crest of the Tidal Wave, 1995; Popular Culture
and the Stock Market, 1992; Prechter's Perspective; and with
R. Frost, Elliott Wave Principle, 1979.
[12]
A. Arneodo et al, "Fibonacci Sequences in Difussion-Limited
Aggregation", in J.M. García-Ruiz et al, editors, Growth
Patterns in Physical Sciences and Biology, Plenum Press, 1993.
[13]
Discrete scale invariance, as developed by D. Sornette, "Generic
Mechanisms for Hierarchies", InterJournal Complex Systems
127, October 15, 1997; "Discrete Scale Invariance and Complex
Dimensions", Physics Reports 297, 1999.
[14]
Arneodo et al., put it this way: "[T]here is room for
"quasi-fractals" between the well- ordered fractal hierarchy
of snowflakes and the disordered structure of chaotic or random
aggregates". Prechter uses the term robust fractal. They differ
from fractals as defined by Mandelbrot, in that there is no
self-similarity.
[15]
G. Bateson , "Form, Substance and Difference" in Steps
Toward an Ecology of Mind, Chandler, 1972, p. 449. Also R. G.
Collingwood, The Idea of Nature, Oxford, 1945.
[16]
A theme running through accounts of the 1920s, according to R. Schiller,
Irrational Exuberance, Princeton University Press, 2000, p. 115.
[17]
Non self-similar fractal behavior, i.e., not simple but complex fractal
behavior.
[18]
D. Sornette and A. Johansen, "Large Financial Crashes", Physics
A, 245, 3-4, 1997.
[19]
Robert R. Prechter, Jr., Wave Principle of Human Social Behavior,
1999.
[20]
"The market has anticipated 12 of the last 9 recessions"
[21]
Robert Lucas , "Understanding Business Cycles", in K. Brunner
and A. H. Meltzer, Eds., Stabilization of the Domestic and
International Economy, North Holland, 1977, p.15.
[22]
Frank Knight, a leading Professor of Economics at the University of
Chicago, teacher of several Nobel Laureates.
[23]
R. Solow, "Toward a Macroeconomics of the Medium Run", J.
Economic Perspectives, Winter 2000.
[24]
Robert R. Prechter, Jr., private communication with the author.
[25]
Early in the century, some economists were well aware of the importance
of these waves of optimism and pessimism. A.C. Pigou, Industrial
Fluctuations, London, Cass, 1927; The Economics of Welfare,
London, Cass, 1920. And J.M. Keynes, The General Theory of
Employment, Interest and Money, London: Macmillan, 1936, chapter 12.
[26]
An expanded treatment of this process appears in H. Cortés Douglas,
"Forewarnings", processed, Catholic University of Chile,
January, 2001.
[27]
James Buchanan, What Should Economists Do?, Liberty Press, 1979.
Buchanan is clear that so-called macroeconomics does not pass the test.
It is neither economics nor science. I agree.
[28]
Robert R. Prechter, Jr., Wave Principle of Human Social Behavior,
1999
[29]
"To a first degree" allows for subsequent feedback.
[30]
There may be several alternative explanations of why stock market
patterns are exogenous. Most likely the explanation may have to do with
interactions among individuals in a context of uncertainty. Bob Prechter
has a powerful hypothesis, as presented in his Wave Principle of
Human Social Behavior, 1999. Among economists, Robert J. Shiller,
Professor of Economics at Yale, is the leading representative of the
view that "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", Irrational
Exuberance, Princeton University Press, 2000
 Hernán
Cortés Douglas is Professor of Economics at the Catholic University of
Chile. He thanks Bob Prechter for valuable comments on an earlier
version.
A revised version under
the title "Toward a Revolution in Macroeconomics" will
appearing this October in The
World and I Magazine.
Chile,
24 January 2002
© 2002-2003 Hernán
Cortés Douglas Email
as published on
Gold-Eagle.com January 24, 2002
~ reprinted with permission from Prof. Douglas ~
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