In 1953, Milton Friedman wrote out what have been the guiding principles of modern, orthodox economics that were necessary should it wish to join the ranks of serious science. In his Methodology of Positive Economics, Friedman recognized economics unlike harder sciences proceeds from an enormous disadvantage, meaning that for the most part all of it is unobservable. We know that an economy happens and that there are observable conditions that relate to the immense and complicated interactions that make up any economic system, but to figure out exactly how A becomes B is all but impossible. You and I may arrive at the same place, economically or financially speaking, but the way in which we did might be extremely different and that might be important.  

This was, of course, Adam Smith’s “invisible hand” of free market economies where social progress was a product of mutual interdependence. But economists of the post-Great Depression era were concerned that because so much was invisible leaving it up to markets alone was too messy and far too often violent. Many, like Friedman, were actually concerned that without a more central role for someone (it was only human that economists saw themselves in that role) that free markets altogether would be subsumed by raw statism, as so many other places had already experienced. To them, to save it was to corrupt it.

To get to that place of a more delimited and therefore “optimal” structure meant that economists had to overcome this information limitation. This is what Positive Economics meant to accomplish, to set out the rules by which economists could still fulfill their self-selected goal even with that possibly disqualifying handicap. In truth, Positive Economics was and remains quite simple as I wrote back in July:

To get to this point, Friedman claims a hypothesis must be “important”, by which he defines as, “if it ‘explains’ much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of them alone.” In statistical usage, this is justification for ignoring the “error” terms so long as the few independent variables supply sufficient predictive capacity. [emphasis added]

In terms of the activist central banks that followed from this thinking, Alan Greenspan’s Fed, for instance, could stake a claim to economic control by nothing more than the federal funds rate even though they truly had no idea how that “control” actually worked. That much they were unconcerned about because the mathematical correlations of that time showed a high degree of relationship between all the important economic variables leading back to short-term interest rates. Greenspan didn’t need to understand how or why, according to Positive Economics, he just needed to be assured that he could explain a whole lot (borrowing, inflation, economy) by a very little (the federal funds rate); which he believed he did and so did “everyone” else.

It was this myth that sustained the Fed through failure after failure after failure, starting back even during Alan Greenspan’s later tenure. Economists still haven’t come to terms with the dot-com bubble, thinking by the middle 2000’s that it they never would be forced to because by then genius “stimulus” of once more nothing but the federal funds rate had overcome any necessary accounting of it. When starting in 2007 they were again proven wrong, it once more followed in their thinking that nothing would matter so long as the “stimulus” was once again applied, as QE was simply the next “logical” step for the federal funds rate once it hit the zero lower bound.

As was obvious to anyone outside the profession (except to the media and politicians who somehow defer to economists on every question), nothing worked. Rather than admit this established fact, they demurred; first by insisting that it was working just that more “stimulus” was needed to achieve the desired recovery, and then claiming that it had worked but “transitory” factors had impeded its arrival sufficiently that it was then delayed. It is actually quite impressive if almost criminally so that central bankers managed more than seven years with just those two excuses.

They are now out of time and no longer in possession of enough ambiguity by which they can further avoid direct questions. The August Jackson Hole conclave was this year far different in that respect; it should have been given the title “What Now?” Janet Yellen spoke last Friday as if she had just re-read (assuming she ever read) Friedman’s full anthology Essays on Positive Economics. Her speech might easily have been called “We Don’t Know Nearly Enough About The Economy.”

It has been the biggest lie of the latter half of the 20th century and so far of the 21st: economists are believed to be experts on the economy. They are not; they are statisticians and Yellen’s speech leaves absolutely no doubt as to this fact. She starts out by making an astounding claim:

For example, hysteresis would seem to make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn, thereby limiting the supply-side damage that might otherwise ensue. In addition, if strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand.

Technical jargon aside, the message is clear enough. Most people would respond to her by exclaiming, “what the hell have you been doing?” All we have heard since the “unexpected” panic was how “accommodative” monetary policy would be, exemplified by quantitative easing in increasing doses. Now she says that “policymakers may want to aim at being more accommodative during recoveries?” But what she really said is that economists are starting to realize what was wrong was not necessarily QE but “under the traditional view” with which it was designed.

And it is where these mistakes have been made that is most exasperating. Economists, people caught up in their math, are now suggesting that they really needed more common sense and maybe less religious devotion to correlations of past conditions that they believed were ironclad rules.

More generally, studying the effects of household and firm heterogeneity might help us better account for the severity of the recession and the slow recovery. At the household level, recent research finds that heterogeneity can amplify the effects of adverse shocks, a result that is largely driven by households with very little net worth that sharply increase their savings in a recession. At the firm level, there is evidence that financial constraints had a particularly large adverse effect on employment at small firms and the start-up of new firms, factors that may be part of the explanation for the Great Recession’s long duration and the subsequent slow recovery.

Again, public response to this “suggestion” might be something like WTF. Small businesses might not respond to panic and “recession” the same as large business backed by the Treasury Department? Households heavily indebted might not be so enamored with low interest rates or the negative real interest rates of QE as those without so much credit? The Chairman of the Federal Reserve claims that it is now necessary to study whether or not people and firms act differently. I am not in any way surprised that I just wrote that sentence, but I suspect the vast majority of people in the world would be stunned by it. Alan Greenspan’s reign was truly the dumbing-down of economics because during it these economists really believed simple, common sense ideas were immaterial. As Yellen recalls in her speech, they just assumed that they could model but one kind of “average household” as sufficiently representative of all the rest.

For example, rather than explicitly modeling and then adding up the separate actions of a large number of different households, a macro model might instead assume that the behavior of a single “average” household can describe the aggregate behavior of all households.

This leads her to but a possibility that almost everyone has known since they were young children (but must have been “schooled” out of economists):

For example, spending by many households and firms appears to be quite sensitive to changes in labor income, business sales, or the value of collateral that in turn affects their access to credit–conditions that monetary policy affects only indirectly.

Under central bank operations of the “maestro’s” persuasion, none of that mattered because “stimulus” of low interest rates just “worked”; exactly in the same way astrologists claim what they do also “works” – post hoc ergo propter hoc. In reality, however, that wasn’t ever really the case, and because economists were so uninterested in the real economy they never bothered to actually verify that it was or they would have seen it. Any unbiased, grounded examination would have shown that the correlation between interest rates, especially the federal funds rate alone, was dubious, at best related to the limited circumstances of individual time periods. In other words, the statisticians made the biggest error in all of statistics, confusing correlation for causation.

Most concerning to Yellen appears to be inflation, and for good reason. As noted last week, the Fed is losing control with increasing doubts about what monetary policy actually is (and if more people were to read her speech these doubts would be validated as well as becoming viral). She is very aware that expectations are falling when they should have been rising all this time. Once more she admits that economists simply don’t know.

Another gap in our knowledge about the nature of the inflation process concerns expectations. Although many theoretical models suggest that actual inflation should be most closely related to short-run inflation expectations, as an empirical matter, measures of long-run expectations appear to explain the data better. Yet another unresolved issue concerns whose expectations–those of consumers, firms, or investors–are most relevant for wage and price setting, a point on which theory provides no clear-cut guidance. More generally, the precise manner in which expectations influence inflation deserves further study.

Given that she believes expectations were anchored by essentially the Greenspan Fed’s expert performance during the Great “Moderation” she once more proves that economists only realize that what they have been doing didn’t work; that she, and likely they, are nowhere near close to ready to realize why. In other words, she has it all still backward, where she assumes that the correlations of the 1990’s were actually good rules and that it is conditions in the 2010’s that are of different sets of circumstances. Again, economists mistook limited correlations then or universal rules and misapplied them as valid for all times and conditions.

In short, at this point she remains devoted to the statistics if however forced to grudgingly recognize they didn’t work. Rather than question fully the math, she suggests they look at this current case as an “exception” rather than the disqualification she seems to now fear it might be (rightly) taken as.

Had economists been expert at anything like economy they would have seen that, but devotion to Positive Economics was blinding. The fatal conceit with all of this is that it applies only to a static world; even if you could actually explain a lot knowing so very little as economists clearly do, that still doesn’t mean you can always explain a lot by knowing very little. The world doesn’t stand so still.

There is actually much more to her speech that deserves highlighting if for nothing else how it flies in the face of the image central bankers have carefully crafted for themselves all during these decades. These are supposed to be the “best and brightest” who have all the answers on markets and economy, and in the media and in politics they are still treated with full reverence in this manner. Reading Yellen’s speech, however, you are left with the distinct impression that she actually knows less than the average household.

I have been writing for years that they really don’t know what they are doing. For once, the Fed Chair opened that door. When it (eventually) swings out wide enough, the recovery can begin.