Marcus Nunes directed me to an interesting quotation from Bill Gates:

Too bad economists don’t actually understand macroeconomics,” . . . It’s not like physics where you take certain inputs and you predict certain outputs. Will interest rates ever return to normal, and why aren’t they returning to normal? You won’t get a consensus between economists quite the way that if you dropped a ball out your window and called up physicists and asked, ‘What the hell happened?’ There’s so many factors including what [economist John Maynard] Keynes called ‘animal spirits’ in the economic equation that we don’t have predictability. Even today, people are still arguing about what happened in 2008. So it’s even harder to look forward. [Look at] the role of the bond rating agencies in 2008, which is completely unreformed. Why would that be? Well, there must be a lack of consensus.

I like Bill Gates, but this is an example of how people worth $100 billion get listened to on subjects outside of their area of expertise. The physics analogy is silly, and proves exactly the opposite of what Gates assumes. “Macrophysics” (predicting complex physical systems such as hurricanes and earthquakes) does just as poor a job of prediction as macroeconomics.

Nonetheless, Gates is onto something here. Macroeconomics really does have problems that macrophysics does not, and “animal spirits” lies in the center of the confusion. While we cannot predict earthquakes and hurricanes with any precision, we do understand the forces that cause them. I’d argue that most economists don’t understand what caused the 2008 recession, even a decade later.

In my view, most American business cycles are caused by demand shocks, i.e., changes in current NGDP. And those demand shocks are caused by unstable monetary policy, i.e., changes in expected future NGDP. While most economists agree with my claim that US business cycles are mostly caused by demand shocks, they disagree on the claim that the root problem is unstable monetary policy.

Because most economists don’t know how to recognize unstable monetary policy (due to their “reasoning from price changes”), they follow Keynes in putting an “animal spirits” fudge factor into their models. Their models can’t explain why aggregate spending falls, so they assume that some sort of mysterious pessimism has suddenly developed in the minds of millions of entrepreneurs.

Because of the law of large numbers, aggregate business and consumer psychology doesn’t suddenly change for no reason at all. The real problem is modeling the policymakers. We don’t know exactly how the 12 members of the FOMC will behave. Of course Trump is even more of a wild card, on the “real business cycle” side of things.

When macro policy is relatively sound (as during the Great Moderation), there is less emphasis on fudge factors such as animal spirits. When it is not sound, as in the post 2008 period, then voodoo economics takes over.

PS. Here’s another way to make my point about physics. Physicists insist that the behavior of all particles can be explained by the laws of physics (or else is random.) In that case, any failure to accurately predict any physical system that is not due to quantum uncertainty must be a failure of physics. These comparisons with physics are beyond stupid. It would be like a mathematician who studies basic arithmetic claiming his field was more successful than the study of prime numbers.

PPS. The Fed cut its fed funds target by 1/4% this week. Yawn. (Should have cut by 50 basis points.)

Update: I’m no expert on reserve management, but this old George Selgin post is looking increasingly prescient.