## Monday, January 29, 2018

### On prediction parables

Josh Hendrickson at The Everyday Economist has a post (H/T Mark Thoma) "On Prediction" that illustrates the underlying problem I have with macroeconomic "parables". In his post, he tries to write a parable about a child and spilled milk that is supposed to be a metaphor for prediction and mitigation of business cycles.
Suppose that you are a parent of a young child. Every night you give your child a glass of milk with their dinner. When your child is very young, they have a lid on their cup to prevent it from spilling. However, there comes a time when you let them drink without the lid. The absence of a lid presents a possible problem: spilled milk. Initially there is not much you can do to prevent milk from being spilled. However, over time, you begin to notice things that predict when the milk is going to be spilled. For example, certain placements of the cup on the table might make it more likely that the milk is spilled. Similarly, when your child reaches across the table, this also increases the likelihood of spilled milk. The fact that you are able to notice these “risk factors” means that, over time, you will be able to limit the number of times milk is spilled. You begin to move the cup away from troublesome spots before the spill. You institute a rule that the child is not allowed to reach across the table to get something they want. By doing so, the spills become less frequent.
What is wrong with this parable? We are being set up.

• First, macroeconomists don't actually know what a recession is or what causes economic growth. In this parable, you'd have to change the specificity of a glass of milk being spilled in the parable with something more like "something happens with this unknown substance in a container".
• Second, we don't know if there is a "child" — we do not know if recessions are caused by endogenous or exogenous factors to the "substance". Saying the milk knocks itself over is silly in this parable, but may well be what happens in an economy using the analogy where milk is growth and spilled milk is a recession. The container is effectively inside another room and we only get imperfect acoustic or electromagnetic readings.
• Third, since they don't know what recessions are, macroeconomists can't possibly know what prevents recessions. Adding a lid and moving the cup (things that obviously prevent spilled milk) become "attach a component to the container" and "manipulate the container". Re-written, these actions no longer contain bias of an implicit model.

Let's rewrite this parable:
Suppose that you are a scientist studying an unknown substance in a container kept in quarantine brought back from Alpha Centauri by a probe. Every day, you weigh the container to ensure the substance is still in the container. You occasionally register strange periods of electromagnetic radiation and acoustic bursts. You label these periods "emissions". You try various experiments: irradiating the container with high energy gamma rays, exposing it to acoustic shocks, or heating it. You flip the container over a couple of times. You notice that the "emissions" become less frequent. Since you are a scientist, you draw no conclusions whatsoever because the active component or components of the substance could potentially decay on their own or depend on factors you haven't controlled for.
People start asking why the scientists can't predict the emissions. The scientists answer: because we don't understand the substance. It might be an inherently unpredictable quantum process, but that's just one theory. Nobody has produced a theory that predicts the emissions, but that does not mean one doesn't exist. Scientists admit that a theory that was able to predict emissions would go a long way toward demonstrating an understanding of the substance, but also note that prediction is not the only way to demonstrate such understanding.
Hendrickson claims that recessions are unpredictable, but mitigated by policy. In our parable, he is some theorist promoting some specific theory that the substance is inherently random, but affected by manipulating the container (let's say his theory says flipping it over mixes the substance inside, causing the two immiscible components that generate the emissions to mix, reducing the average distance between regions and thereby reducing the magnitude of the emissions that depend on the substances being separated). That is to say Hendrickson's version of the parable assumes an implicit specific theory of what he is writing the parable about.

I personally think the "scientific" approach of saying "we don't know" when in fact we don't know is a far superior way of dealing with public criticism of macroeconomics than the "we do know, but it's unpredictable" approach — the former approach having the benefit of being both true and an excellent way to counter people who claim to know with meager evidence.

Macroeconomists taking the latter approach may well be behind the proliferation of "heterodox" approaches because a lot of "mainstream" economists can't seem to bring themselves to say no one has sufficient data to make strong claims about economic growth or recessions. The public has a strong desire to understand the world and e.g. politicians can offer that understanding with precisely the same level of empirical confidence macroeconomists muster in the face being unable to predict outcomes (i.e. close to zero).

The other problem is that claiming knowledge where none exists undermines macroeconomists' claim to knowledge where it does exist: minimum wages have very limited negative effects on employment if at all; fiscal austerity is bad during a recession; and immigration doesn't hurt and may help economic growth. I'm not saying there aren't studies out there that show at least some empirical regularities.

I am completely on board with the idea that recessions could well be unpredictable, and that being unable to predict something isn't in itself a valid criticism on its own. The current state of knowledge in macroeconomics is such that recessions are "unpredictable" because we don't know if recessions are predictable, not that they are "unpredictable" because we know they cannot be predicted. This is a subtle point and one prone to being elided through pretending knowledge where it does not yet exist.