The Difference Between Economics and Natural Science

Jim Grant, editor of Grant’s Interest Rate Observer, earlier this month testified before the American Congressional Subcommittee on Monetary Policy.

Right at the start of his ‘lecture‘ titled “What Does the Fed Do?” he explains why the hang-up over central bank or any econometric forecasts are a fool’s game. After discussing the Federal Reserve’s newfound role of economic forecaster, which wasn’t a role given the institution when it was founded in 1913, he explains why it is doomed to failure:

“For here we encounter the difference between physics and economics. Both use quantitative methods to build predictive models, but physics deals with matter, economics confronts human beings. And because matter doesn’t talk back or change its mind in the middle of  a controlled experiment, or buy high with the hope of selling even higher, economists can never match the predictive success of scientists who wear lab coats.

If you believe that human action is unpredictable, you will not be overly impressed by econometric forecasts of next year’s GDP. Still less will you share the confidence of some Federal Reserve officials in the ability of interest rate manipulation to herd human beings in the desired direction.”

In other words, because in economics we deal with human beings who can change their subjective values with little warning at a whim, we cannot use any quantified metrics to test our theories or to make economic predictions. Our theories of human action are based on a priori reasoning of the universal laws of economics.

Trying to quantify human action is a fool’s game, and is also the reason why the majority of Keynesian economists, including the Federal Reserve completely missed the bust of the US housing market.

Watch the full lecture here.