Calling the Bust

By Noah Clarke.

Yale Professor Irving Fisher

On October 22, 1929 the following headline ran in the Washington Post: “Bank Stocks Gain in Spite of Upset: Turmoil Fails to Shake Confidence in Soundness of Securities.” Reporter Thomas Cahill went on to write that the business community felt there was nothing “fundamentally wrong” with the country’s economic situation. About midway through the article, Cahill reminded readers that the pre-eminent American economist, Yale professor Irving Fisher, would speak the following night at the District of Columbia Bankers Association dinner to be held at the Willard Hotel.

High ranking officials from the Treasury Department and Federal Reserve packed the hotel to hear Professor Fisher’s talk. After discussing in general why stocks advance and some of the reasons for the nation’s productivity growth over the previous decade, Fisher noted that recent market turbulence was simply eliminating individuals who shouldn’t have been investing in the first place. He then went on to predict a bull market for the New Year. The next day, October 24, 1929, panic hit the New York Stock Exchange as investors rushed to sell. It was Black Thursday, the beginning of the Great Depression.

Almost eighty years later to the date, Larry Kudlow, host of the popular CNBC business program The Kudlow Report, former economic advisor to President Ronald Reagan, gave his assessment of the economic situation. While acknowledging the housing recession and the reticence of banks to lend, he praised the “low-inflation, low-interest rate” climate and wished analysts would give “give this economy—the greatest-story-never-told—just a little credit. The fact is that stock prices are hovering near record highs, inflation is coming down, growth is going up, and jobs are going up.”

We know now October 2007 was the market peak. Over the next year and a half, the Dow Jones Industrial Average fell forty-seven percent. In fact, 2008 would be the worst year for stocks since the early nineteenth century. The only year as bad as 2008? 1931.

Kudlow, of course, was not alone in his optimism. In a speech on May 17, 2007 about sub-prime mortgages, Federal Reserve Chairman Ben Bernanke explained that “given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” He assumed that “growth in jobs and incomes should help keep the financial obligations of most households manageable.”

Theory and Pretence of Knowledge

This is not to say the experts should have predicted the timing or severity of either the Great Depression or the current economic crisis. The knowledge available to any one person at any one time is necessarily incomplete. In the physical sciences it can be assumed with relative security that a) all the factors involved in producing a particular change can be observed and that b) they react in identical fashion time and time again. This allows physicists or chemists to make reliable predictions. There are no such constant relationships in economics. Friedrich Hayek said in his Nobel Prize lecture:

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…will hardly every be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement.

The attempt on the part of mainstream economists to squeeze their discipline into a mathematical corset has created the illusion (or delusion) that experts can predict the market’s actions with precision. Economics, however, is not blind, it is simply limited. The theory for which Hayek argued “allows [economists] to make very general predications of the kind of events which we must expect in a given situation…and I confess that I prefer true but imperfect knowledge, even if it leaves much indetermined [sic] and unpredictable, to a pretence of exact knowledge that is likely to be false.”

Pattern predictions are within the realm of economics. For example, as early as 1924 Austrian economist Ludwig von Mises saw the makings of a great depression. One of his students at the time, Fritz Machlup, described how during their Wednesday walks together through the Kreditanstalt in Vienna, Mises would warn of a “big smash” coming. In the preface to the 1953 edition of his book The Theory of Money and Credit, Mises reflected on his thinking before the “smash” hit:

From 1926 to 1929 the attention of the world was chiefly focused upon the question of American prosperity. As in all previous booms brought about by expansion of credit, it was then believed that the prosperity would last forever, and the warnings of the economists were disregarded. The turn of the tide in 1929 and the subsequent severe economic crisis were not a surprise for economists; they had foreseen them, even if they had not been able to predict the exact date of their occurrence.

Of course, Mises never said when the crisis would strike and probably never imagined it would last as long as it did. Such specificity is beyond human knowledge. Nevertheless, a correct theory permits economists to deduce the consequences particular actions tend to have on the market. Applying thinking similar to that of Mises, economist Stefan Karlsson, writing in 2004, worried American consumers’ lack of savings and outsized indebtedness posed a serious threat to the economy. Frank Shostak, chief economist at M.F. Global, noted the financial bubble in August 2005, a solid two years before the real trouble began. The challenge for the economics profession is to reexamine its theories and challenge the status quo. Mises, Hayek and others described a way of thinking about the business cycle that fit events. Perhaps it is time to take their ideas more seriously.

Noah Clarke is an economist.

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