Regime Uncertainty: Reports Keep Coming In
By Robert Higgs • Sunday September 12, 2010 1:59 PM PDT • 36 Comments
Each summer, Wall Street strategist Byron Wien convenes a meeting of high rollers to discuss the outlook for investment. This year’s meeting brought together fifty individuals, including more than ten billionaires. Their expectations, as reported by CNBC, are gloomy:
“They saw the United States in a long-term slow growth environment with the near-term risk of recession quite real,” said Wien, in a commentary to Blackstone clients. “The Obama administration was viewed as hostile to business and that discouraged both hiring and investment. Companies and entrepreneurs were reluctant to add workers because they didn’t know what their healthcare costs or taxes were going to be.”
Add this report to the many similar ones to which my colleagues and I have called attention over the past two years.
Of course, for mainstream macroeconomists, such evidence means nothing. In fact, they hold it in complete contempt because (1) their formal mathematical models do not have a variable called “regime uncertainty,” and (2) even if they could be persuaded to take this factor into account, the canned data on which they rely—the product of the Commerce Department’s Bureau of Economic Analysis, for the most part—do not supply them with an “official” data set for their analysis. What you can’t measure, according to their “scientific” credo, does not exist. Their de facto motto (of which I have more than once been on the receiving end) is: you’ve got no formal model; you’ve got nothing.
In my study of regime uncertainty over the past fifteen years, I have given weight to three independent forms of evidence: (1) specific legislative, executive, judicial, and regulatory actions the government is taking, the ideology embraced by major government actors and advisors, and, in light of basic economic logic, what investors might reasonably infer about the future security of their private property rights from the government’s actions and the ideology of its leading figures; (2) direct testimony by investors themselves, as well as relevant opinion surveys of businessmen, when available; and (3) changes in risk premiums demanded by investors in the corporate bond markets, as shown by changes in the slope of yield curves. During the past two years, my scrutiny of these types of evidence has persuaded me that regime uncertainty has arisen and that this uncertainty probably accounts, at least in part, for the very low level at which long-term private investment has settled, with only relatively small recovery since it hit its most recent trough.
Again, however, full disclosure obliges me to warn the reader that the acknowledged experts in macroeconomics—those who work in this area at MIT, Stanford, Harvard, Chicago, Yale, Princeton, and the other esteemed universities—are to my knowledge unanimous in their disregard of the idea that regime uncertainty might be contributing to the prolongation of the present recession (or might have contributed to the prolongation of the Great Depression, as I argued in my 1997 paper). So, if you prefer to go with the experts, you should disregard my argument and my evidence and make your bets on the basis of what the experts say. You might wish to consider, however, that these are the same experts who, virtually to a man, failed to predict the present recession (and most of the preceding ones, as well) and that, according to their positivistic tenets, predictive power is the sine qua non of a scientific theory, as much in economics as in physics or chemistry.
Tags: American History, Budget and Tax Policy, Business, Economics, Government subsidies, Mercantilism, Money and Banking, Politics, Property Rights, Science, Taxation, Unemployment 
Dr. Higgs,
In your opinion, how much studying must a layman do before he is justified in disagreeing with the majority consensus of experts in economics?
Neal W. | Sep 12, 2010 | Reply
Dear Neal,
Anyone can disagree with the consensus of experts in economics, and a great many people do so. There is a difference, however, between an uninformed or gut-feeling disagreement and a well-informed disagreement. Often one must have mastered a discipline before one can criticize it knowledgeably. This necessity helps to explain why insiders routinely dismiss criticism by outsiders: the outsiders are said, with some basis, not to know what they are talking about. Although this situation applies less in economics than in physics, chemistry, and other well-developed (physical and biological) scientific disciplines, it still applies.
I had the benefit — if that is the right word — of being trained in neoclassical economics at Johns Hopkins and of working as a neoclassical economist for many years. If I may say so myself (as a famous Austrian economist used to say about his prowess as a pilot in the Luftwaffe), I vas goot hat it, too! Eventually, more and more self-education in Austrian economics ruined my academic career, however much it might have improved my understanding of economic reality. In any event, though, I am probably in a stronger position to criticize mainstream economics than someone who has not spent many years learning and practicing it. Of course, the experts may still feel perfectly free to dismiss my criticism on any number of grounds, not excluding the ground that I am an idiot.
Robert Higgs | Sep 12, 2010 | Reply
As usual, I am a bit hesitant to follow Dr. Higgs in my comments.
But I must say that sometimes a gut-feeling disagreement may put one on the right track. For example, some of my misgivings about conventional economics (e.g. the notion that war could be good for an economy and that economists could, in effect, decide what is best for us) were of this nature and were what led me to Austrian economics.
As far as predicting future economic activity goes, though, I am afraid that my intuition does not seem to help much in this regard!
D. Saul Weiner | Sep 12, 2010 | Reply
How many times will these “experts” be surprised by “unexpected” events before we cease to call them experts?
A G | Sep 13, 2010 | Reply
Dear Dr. Higgs,
While macroeconomics may not recognize the importance of regime uncertainty as such, those of us in finance certainly do. The importance of regime uncertainty to corporate investment decisions can be seen in the idea of the real option value of delaying investment. The more uncertain we are about the future, the more valuable the delaying option becomes. Regime uncertainty is one – important – source of overall uncertainty.
By the way, thank you for your original 1997 paper. It helped to solidify my understanding of why investment is so sensitive.
Jeff Oxman | Sep 13, 2010 | Reply
Adam Smith was self-educated and learned nothing from the tenured “deadwood” in later years. JS Mill was home schooled by his father. I could probably go on with a list of people who weren’t “trained,” “certified,” and “stamped with the approval” of “x” discipline.
For that matter, nearly all my best students were home schooled and self-educated (the two often, though not always) go together.
In fact, as I recall, Keynes was an outsider and not a trained economist — Hayek noted this but said it took nothing away from the challenge of Keynes’s ideas.
We in America are far too respectful of academic authority (odd, since we despise all other authority)
Jonathan Bean | Sep 13, 2010 | Reply
I love the implication in statements like this.
You are wrong because most experts think you are wrong. Of course, it is a logical fallacy, but never mind that. Stop and consider that many ground breaking ideas in science started out this way. Take for example the endosymbiotic theory of eukaryotic cells. Initially considered quackery. Then there is the H. pylori ulcer theory, also initially dismissed as quackery. In neoclassical economics public choice theory was considered looney for quite awhile.
Of course, I’d argue that new theories, hypotheses, etc. should face a strong uphill fight. After all, we don’t want to give every half-baked notion equal credence with theories that have been very successful. Basically it should all boil down to the evidence and data.
Dr. Higgs is right that many mainstream economists want nice mathematical theories that one can apply easily understood data too. I know, like Dr. Higgs, my training was in neoclassical/standard economic theory. I went through the micro courses that used constrained optimization, game theory, and such. I also ground through the courses on macro-economics with a representative agent solving a dynamic constrained optimization problem using dynamic programming, optimal control theory and the like.
However, lets consider this. Take a micro model in regards to investments. Now vary the level of risk. Assume that “there is an external shock” and that investment becomes more risky. Look and see what happens. Does investment go up or down? Now expand it a bit by adding in a “safe investment”. Then what happens? In periods of increased uncertainty, do investors run to the “safe investment” that isn’t nearly as productive in the long run?
And consider this, when the government told Lehman, “Sorry you’re on your own,” was that increasing or decreasing regime uncertainty? I would certainly say it increases uncertainty about one’s investments. Up to that point many may have believed that the downside to their investments was very limited: we’ll get a bail out from Uncle Sugar; private profits and public losses sort of thing. Suddenly Uncle Sugar says, “Well maybe not.” Quite a few commentators have pointed to that incident as being a key factor that really spooked the markets.
I’d also argue that mathematical models can be helpful and useful. At the same time, I’d also caution those who use them to not become so enamored with them that they lose site of reality. All models are wrong....all of them even models in physics and some are useful, even in economics. At the same time, dismissing all (mathematical) models as just mental masturbation does leave one open to becoming very confused and muddled in one’s thinking.
Steve Verdon | Sep 13, 2010 | Reply
Dr. Higgs, did you predict the current recession?
f4kingit | Sep 13, 2010 | Reply
Dear f4kingit,
I did not predict the current recession. I do not attempt to predict turning points in the business cycle. Moreover, I believe that anyone who has successfully predicted a series of such turns accurately has done so by chance. Business fluctuations hinge on so many factors, many of which are more or less random in their occurrence, that such precise prediction is a chimera.
However, I am pleased to plead not guilty to having swallowed any of the widely popular ideas that preceded this recession, such as the idea that real estate prices would continue to rise forever, the idea that the Fed had come to have pinpoint control over both business fluctuations and the rate of inflation, and the notion of a Great Moderation, which denoted a permanent reduction in the volatility of fluctuations around the economic growth trend. All talk of a New Era is bogus. Every crash has been preceded by such wishful or mistaken thinking.
In my view, mainstream economists delude themselves by supposing that a few more tweaks of their macro models will allow them to forecast aggregate economic movements accurately. I deny that aggregate economies can be usefully characterized by a few equations whose parameters will remain constant (or change predictably) over time. Economics is not physics or astronomy. The economy is not analogous to a bunch of rocky spheres flying around in orbits.
However, I agree with Hayek that we can rely to some degree on what he called pattern prediction. So, for example, if we see asset prices (e.g., real estate, corporate stocks) racing upward at rates greatly in excess of the economy’s overall growth for years on end, we can predict that a bust awaits us sooner or later. Still, to repeat, no one, not even the ablest Austrian economist, can predict exactly when the bust will occur. Good economists can gain an understanding of how economies tend to operate, yet still (necessarily) fall short of the physics-envy pretensions of modern neoclassical economics.
Robert Higgs | Sep 13, 2010 | Reply
So...health care....?
Seems to me that has been the case with health care spending for quite some time. Of course, I think the dynamics are a bit different with health care than with housing, but I do agree that we will eventually see a bust regarding health care.
We are clearly on an unsustainable growth path, and as Herb Simon has noted, unsustainable trends are not sustained. When the bust will come and what it will look like, I have no clue other than it likely wont be pretty.
Steve Verdon | Sep 13, 2010 | Reply
“You are wrong because most experts think you are wrong. Of course, it is a logical fallacy, but never mind that. Stop and consider that many ground breaking ideas in science started out this way. Take for example the endosymbiotic theory of eukaryotic cells. Initially considered quackery. Then there is the H. pylori ulcer theory, also initially dismissed as quackery. In neoclassical economics public choice theory was considered looney for quite awhile.”
You are mistaken, there is no logical fallacy here.
Appeal to popularity goes something like this: “For any outsider belief B, if expert consensus is ~B, then B is false.” Or conversely, “If expert consensus is B, then B is true.”
However, I never stated any such position. My question asked about the justification for belief in B. Consensus about B does not entail that B is true (which is what you are accusing me of stating) but it is strong evidence in favor of B, especially for the layman.
Neal W. | Sep 13, 2010 | Reply
Only a fool would disregard the interaction of the power elite and the masses in sizing up the economic potential of a country. Mathematical models cannot capture this. For those other readers out there I suggest you read Professor Higgs’ book Crisis and Leviathan to see an example of how to do some real economic analysis.
aegeanwealth | Sep 14, 2010 | Reply
Dear Dr. Higgs
Your statement “I deny that aggregate economies can be usefully characterized by a few equations whose parameters will remain constant (or change predictably) over time” seems a perfect argueing point for the global warming farce if one replaces the term “aggregate economies” with “global atmospheric patterns”. And it seems that the two disciplines defy prediction for the same reason.
Thank you for your reasoned discussions.
Bob | Sep 14, 2010 | Reply
f4kingit,
Please name any mainstream economist that did predict the recession. The gods at the Federal Reserve did not; in fact, Bernanke said the economy was strong. Please try again.
Richie | Sep 14, 2010 | Reply
This is an excerpt from a paper written in 2001 by Hernán Cortes Douglas reprinted in Prechter, Robert R. (2003). Pioneering Studies in Socionomics. Gainesville, Georgia: New Classics Library, pp. 256-265
” The Minneapolis Fed, in October 2000, invited some sixty noted economists to a conference to present research papers on the Great Depression. The event attracted a number of macroeconomist luminaries, including University of Chicago professor Robert E. Lucas Jr., the 1995 Nobel Laureate, and professors from the University of Minneapolis, UC Berkeley, Princeton, Carnegie Mellon and other top universities. All that talent brought to bear notwithstanding, the report on the conference in the Minneapolis Fed Review, The Region, concludes on a rather disappointing note. When economists review the facts surrounding the [Great] Depression, it says, ‘they each time come up with another explanation. The Great Depression is a mystery that is loaded with suspects and difficult to solve, even when we know the ending.’
“By and large the explanation of this failure is that economists have been leaning on so-called macroeconomic fundamentals to attempt such predictions. Have they ever succeeded? The historical data say that they cannot succeed; financial markets never collapse when things look bad. In fact, quite the contrary is true. Before contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons. Despite these failures, indeed despite repeating almost precisely those failures, economists have continued to pore over the same macroeconomic fundamentals for clues to the future. If the conventional macroeconomic approach is useless even in retrospect, if it cannot explain or understand an outcome even when we know what it is, has it a prayer of doing so when the goal is assessing the future?”
“Apparently not. As Lucas candidly observed years ago, ‘Economic reasoning will be of no value in cases of uncertainty.’7 We have learned from Nobel laureate Friedrich von Hayek, his mentor, Ludwig von Mises, and from Frank Knight, a professor of economics at the University of Chicago who taught several Nobel laureates, that uncertainty is normal and pervasive. Given that the future is always uncertain, is Lucas saying that ‘economic reasoning’ has no forecasting value whatsoever? Reasoning per se is not at fault; more and more, it appears that the flaws reside in the conventional economic premises upon which that reasoning is founded. “
David C. | Sep 14, 2010 | Reply
Economic study addresses what people do in a grocery store when buying canned tomatoes. The study of finance examines what people do in the world of uncertainty, and there we find that people herd in a dynamic, non-mean-reverting patterned fractal first identified by Ralph Nelson Elliott in the 1930′s and 40′s. The stock market thus does not “predict” the future (even though it is the only near-perfect leading indicator of economic expansion and contraction). The stock market’s trends simply imperfectly measure the current position and trend of social mood, which is the driver of economic, political, and pop cultural activity.
See http://www.socionomics.net for more.
David C. | Sep 14, 2010 | Reply
Another brilliant observation from Dr. Higgs, one of the finest economists in the world today.
I must note, however, that about ten other “non-PhD” writers I’ve been following for app. ten years on the web DID correctly predict the present recession. They have been right about practically everything all along. Some lesser known examples include Ty Andros, Jim Puplava, Chris Martenson, Jeff Nielson and Jim Willie. I don’t know what their levels of education are, but after reading their opinions and seeing their (quite gloomy) predictions come true time after time, my strong conviction is that they will continue to be on target going forward. In other words, Pollyanna-ish, Keynesian mainstream economists should be listened to *FAR* less than this group (and, of course, Dr. Higgs).
Andrew Fischer | Sep 14, 2010 | Reply
Dr Higgs observations and analysis seems to me so obvious that they could only be missed by the “experts”, you know the kind that fill the ranks of most college faculties, Brain Trusts and the Council of Economic Advisers.
What we see in action today is what Hayak referred to as the fatal conceit, the idea that a grouping of self-proclaimed experts and do-gooders possess the knowledge to successfully plan an economy. Central planning always fails in this regard but it is very useful for the political elite and their corporate clients.
The mask was ripped off our fascist corporate state when Congress, in defiance of public opinion, bailed out Wall Street thus saving the financial system. Of course, it was that very system that needed to be upended.
Tim | Sep 14, 2010 | Reply
Peter Shiff, Ron Paul, and Gary North, to name a few, all predicted the current economic plunge. What none of could predict was the date it would happen, only that it would. The Austrians were right. Almost everyone else, especially mainstream economists and Ben Bernanke were wrong.
Davidus Romanus | Sep 14, 2010 | Reply
“What we see in action today” is simply the fact that dogma is always in service to the Ruling Coalition’s agenda. Macroeconomics is basically all dogma today, existing despite its empirical irrelevance. This will not change until the agenda of the Ruling Coalition changes, and that sort of thing only occurs quite rarely, less than once a century or two as far as I see it.
Such change appears (to me) in process. The consensus of the rulers and the consent of the ruled are evaporating under the pressure of declining social mood. 80 years ago people knuckled under and did what they were told. I doubt the same level of consent still exists.
David C. | Sep 14, 2010 | Reply
Yes it is, it is called an appeal to authority and appeal to popularity. Hmmm, okay you’re right if you meant it is 2 fallacies.
Ideally it should be evidence based and not much else. The history if science is far, far too riddled with people pushing their own personal agendas to trust “consensus” IMO. Look at all the nonsense surrounding the existence of the atom.
Right, and all the examples I gave you...you’d be wrong.
David C.,
I’ve always liked Lucas, who has worked in the mathematical models like no one else, but at the same time isn’t afraid to say things like that
Personally, I think we’ve (the general public) gone too far with our beliefs that the President and the government can do much about bad economic conditions. I like how Gene Healy has described it as it being like a cult. That the President has these infallible powers and will make things right.
Bringing it back to Lucas I think it was Arjo Klammer who asked him once what he’d do if he were in a position to set economic policy. Lucas’ reply, going by memory, was that he’d quit because he didn’t think that sort of thing had much to do with improving the economy.
I think economics big area that it can help in is in things like incentives and making sure we don’t set up perverse incentives...if we are going to have a government vs. an anarcho-capitalist society anyways. I’ve always been doubtful of “macroeconomics” in that reducing the entire economy to two types of unrecognizable lumps (aggregate demand and supply) has been problematic. Hell, even the mathematically inclined macro-economists admit this (google the aggregation problem). This is why so many modern macro papers “assume an representative agent” who may or may not be infinitely lived.
Steve Verdon | Sep 14, 2010 | Reply
The conspiracy theorist in me leads to suspect that the mainstream or pro government economists have conspired to make the study economics so dismal and incomprehensible to the common man that the power elite can get away with ripping off the public. But then that other voice in my head tells there isn’t one single explanation.
Tim | Sep 14, 2010 | Reply
Roubini definitely predicted the collapse. He even had a 12 step description of what was happening well before the crash of two years ago. I recall his warning that we were then on the 12th step months before the panic/crash.
We need to study economics the same as we regard history. It tells us what happened in the past and may, to some extent, help us see possibilities ahead.
I took many college courses in economics years ago, and follow events daily in my retirement years. The detachment of currency from gold and silver really damages any “model” for anticipating the future. Natural forces such as world population and massive environmental pollution are just parts of the equation. The manipulation of money (such as it is) by governments, Wall Street, etc. join with the Regieme Uncertainty discussed here.
RT Carpenter | Sep 14, 2010 | Reply
I read once in the engineering press, a comment on a failed engineering model that may apply equally well to economic models.
“We don’t have model failure – the model is perfect. What we have is reality failure.”
Andrew Stanbury | Sep 14, 2010 | Reply
Steve Verdon,
I’m afraid you are still mistaken. “All the experts believe B, therefore B is true” is different than “All the experts believe B, therefore the most rational thing for me to do is believe B until I know enough about the subject to be critical of their views.”
The history of science suggests that I am more likely to right by believing the consensus than believing an outsider position. How many outsider positions have been proven false compared to consensus positions?
Neal W. | Sep 15, 2010 | Reply
Dr. Higgs:
Thank you for your economic analysis and reasoning.
I am constantly amazed and dismayed by academics and professional economists who dismiss the importance of confidence — or lack thereof — among investors and businessmen!
These academics treat production — the source of all wealth — as if it is a black box with a simple on/off switch. In their view, “sufficient” aggregate demand will move the switch to the “On” position and production will follow automatically — regardless of any other economic factors –
– regardless of how many rules, regulations, limitations, controls and licenses may have been erected to regulate, impede, restrict and penalize production;
– regardless of how many government bureaucracies, commissions, committees, administrations and regulators may have been granted arbitrary power to impose by force the government’s terms and conditions on any economic transactions;
– regardless of what taxes, penalties, fees or duties may be levied against any profits made — profits which are in any case being inexorably looted via inflation;
– regardless of how many insane, 2000+ page bills granting vast new regulatory powers to bureaucrats may be passed, the final effects of which cannot be known for years until government “czars” finish issuing all the new regulations authorized by these vast expansions of government’s powers.
Our current Looter-in-Chief and his fellow power-lusting looters in Congress think none of this matters and that production will go on irrespective of what barriers they might enact — if only they provide enough of that omnipotent economic elixir called “aggregate demand”.
At the end of Ayn Rand’s “Atlas Shrugged”, one of that last remaining producers — steel tycoon Hank Rearden –is informed by the government of a new “steel unification plan” under which the bulk of his sales revenue will be diverted to a crooked competitor who has lobbied the government to impose this scheme.
Rearden asks: “How long to you expect me to continue producing with every ton of steel I pour costing me more to produce than I will receive? How do you expect me to produce after I go bankrupt?”
“You won’t go bankrupt. You’ll always produce,” answers one of the government officials. “You can’t help it. It’s in your blood. Or, to be more scientific: you’re conditioned that way.”
When I first read that book 40 years ago, I thought it was an exaggeration and that no government official could be so stupid. I was wrong. God help us if we don’t vote these looters out in November.
Michael Smith | Sep 15, 2010 | Reply
I’m late to this threat but, who knows, a fact or two might catch someone’s eye.
As an American living in Australia since 1974, I paid little attention to American economic sagas. When my wife died in 2005, I ‘went away from the world for a while.’
It was around April, 2006, when I observed the Fed stopped publishing the M3. A strange clue, perhaps, but it triggered the compulsion to find out what was up. I didn’t find the information at the time, but Australian Dr. Steve Keen realized the U.S. housing market was in a bubble in late 2005. No one then took much notice.
Well, I’ve had four years of self-study, a lot on the internet, but much reading of books as well. I wrote my first economy blog in July, 2007, having extrapolated the fallout from the housing downturn. This was primarily due to seeing so many smug commenters knocking the ‘stupid and greedy, they deserve what they get!’
Yes, well, the ramifications of that bust would obviously, to me, affect a lot of the smug ones, investments, pension funds, and the like.
It’s easy to stand on the shoulders of giants — learning from a host of publications. Mises, Hayek, Irving Fisher, Minsky, and more. A wealth of information on the internet, from here to Thomas Sowell, Gary North, Bill Bonner, Roubini, newsletters from currency to investment to blogs of all shapes and sizes.
Novista | Sep 18, 2010 | Reply