Common Sense Trumps Economic Models and History

October 4, 2011

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There are basically two schools of thought on economic forecasting. The school that dominates the academic elite, and politics, today uses quantitative models to forecast how people behave. Unfortunately, said models are often flawed in that they make unrealistic and often perfect assumptions. They are further distorted by the political and behavioral bias’ of the model’s designer. “If you torture data long enough, it will tell you anything you want,” say critics.

Ben Bernanke’s models told him the subprime crises was “contained.” While Paul Krugman believes the government should spend more on the premis there is an unlimited appetite for debt. “Every debt is someone else’s asset,” he says. Common sense says debt is not someone else’s asset if it goes bad and one cannot solve a problem of too much debt, with more debt. “An unsophisticated forecaster uses models as a drunken man uses lamp-posts – for support rather than for illumination.”

History, especially deep history, can be a valuable guiding light. Ken Rogoff’s 800 year study of financial crises provided a road map for the United States. It accurately forecasted the economic crises, the slow economic growth following, and the coming wave of sovereign debt defaults. Unfortunately, the study of history has been marginalized. “It’s almost impossible to get an appointment at a University with a focus on economic history,” says Harvard Professor Ken Rogoff.  Still, history is often distorted by people who see the world through their own lens.

Ben Bernanke believes there would not have been a Great Depression if you had simply dropped the gold standard and printed vast quantities of money. Others believe the credit bubble of the 1920s made possible by easy monetary policy made the painful deleveraging inevitable. Common sense suggests a printing press is not a new invention that improves the standard of living.  People invent things, not paper. Bernanke wrote his dissertation on the Great Depression, but ignores the Stagflationary 70s and periods of hyperinflation.  Some believe FDR was a hero, while others see the problems of the Great Depression were compounded by protectionism through Smoot Hawley, higher taxes by Hoover, and 7 FDR policies highlighted by the UCLA study below.

Reason is a precondition for using models and history.

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