Verstehen and the Role of Economics in Forecasting, or: If You’re so Rich, Why Aren’t You Smart?
At Recovery or Stagnation?, a Mises Circle held in San Francisco on August 29, 2009, there was a great Speakers’ Panel featuring Walter Block, Thomas DiLorenzo, Douglas French, and Robert Murphy. Great comments on the current financial mess.
One thing that especially interested me were Walter Block’s comments from about 12:45 to 13:35, where he distinguishes between economic theory and one’s ability to predict or forecast. Sure, having a sound understanding of theory can help, but it cannot make your predictions foolproof. For example one’s understanding of the business cycle might lead you to recommend buying gold; but then the state might confiscate gold soon after that.
This brings to mind some discussions I’ve had about the nature of economics and its role in investing or forecasting. My view is the Misesian-Rothbardian-Hoppean one, which I understand to be that the future is uncertain, but not radically so; that knowledge of economics laws can help, ceteris paribus–but that usually other factors are dominant. The skill of forecasting is called the understanding, or verstehen; but it is not merely “luck,” as some in thrall to monism-scientism are wont to deride it. Peter Klein mentioned to me that the question of why or how someone has the better skill at forecasting is really meta-economics–more of a psychological field, which is studied at Effectuation, from a Kirznerian perspective. It could be that one reason Austrian investors don’t dominate is that economic understanding only gives you a second order marginal advantage over others, that psychological or other factors are more important.
In other words, the better your economic understanding, the better a forecaster you can be. The future, while uncertain, is not radically so, and knowledge of economics helps constrain the possibilities. So ceteris paribus a better economics would be a better investor. The problem is the ceteris is not usually that paribus; that economic knowledge is only a small factor of investing success, since it depends also on other factors, which apparently usually tend to dominate-other factors such as the possession of capital to invest; your access to certain knowledge or data; and your investing ability or knack, the leftover part that is more art, that Mises called verstehen. Possible, in times of a typical Austrian business cycle bust, sound economics could play a bigger role in one’s ability to forecast, which could explain why Austrians like Schiff and others are standing out right now.See also Peter Klein’s work on the nature of entrepreneurship, e.g. his Opportunity discovery, entrepreneurial action, and economic organization:
Abstract: This article reviews and critiques the opportunity discovery approach to entrepreneurship and argues that entrepreneurship can be more thoroughly grounded, and more closely linked to more general problems of economic organization by adopting the Cantillon-Knight-Mises understanding of entrepreneurship as judgment. The article begins by distinguishing among occupational, structural, and functional approaches to entrepreneurship and distinguishing among two influential interpretations of the entrepreneurial function – discovery and judgment. It turns next to the contemporary literature on opportunity identification and argues that this literature misinterprets Kirzner’s instrumental use of the discovery metaphor and mistakenly makes opportunities the unit of analysis. The article then describes an alternative approach in which investment is the unit of analysis and link this approach to Austrian capital theory. I close with some applications to organizational form and entrepreneurial teams.
Some more good quotes on this from (what I think of as) the High Austrians:
For the praxeologist, forecasting is a task very similar to the work of the historian. The latter attempts to “predict” the events of the past by explaining their antecedent causes; similarly, the forecaster attempts to predict the events of the future on the basis of present and past events already known. He uses all his nomothetic knowledge, economic, political, military, psychological, and technological; but at best his work is an art rather than an exact science. Thus, some forecasters will inevitably be better than others, and the superior forecasters will make the more successful entrepreneurs, speculators, generals, and bettors on elections or football games.
The economic forecaster, as Professor Jewkes pointed out, is only looking at part of a tangled and complex social whole. To return to our original example, when he attempts to forecast the price of butter he must take into consideration the qualitative economic law that price depends directly on demand and inversely on supply; it is then up to him, using knowledge and insight into general economic conditions as well as the specific economic, technological, political, and climatological conditions of the butter market, as well as the values people are likely to place on butter, to try to forecast the movements of the supply and demand of butter, and therefore its price, as accurately as possible. At best, he will have nothing like a perfect score, for he will run aground on the fact of free will altering values and choices , and the consequent impossibility of making exact predictions of the future.
The argument establishing the impossibility of causal predictions in the field of human knowledge and actions now might have left the impression that if this is so, then forecasting can be nothing but successful or unsuccessful guessing. This impression, however, would be just as wrong as it would be wrong to think that one can predict human action in the same way as one can predict the growing stages of apples. It is here where the unique Misesian insight into the interplay of economic theory and history enters the picture. 
In fact, the reason why the social and economic future cannot be regarded as entirely and absolutely uncertain should not be too hard to understand: The impossibility of causal predictions in the field of action was proven by means of an a priori argument. And this argument incorporated a priori true knowledge about actions as such: that they cannot be conceived of as governed by time-invariantly operating causes.
Thus, while economic forecasting will indeed always be a systematically unteachable art, it is at the same time true that all economic forecasts must be thought of as being constrained by the existence of a priori knowledge about actions as such. 
The quantity theory of money then cannot render any specific economic event, certain or probable, on the basis of a formula employing prediction constants. However, the theory would nonetheless restrict the range of possibly correct predictions. And it would do this not as an empirical theory, but rather as a praxeological theory, acting as a logical constraint on our prediction-making.  Predictions that are not in line with such knowledge (in our case: the quantity theory) are systematically flawed and making them leads to systematically increasing numbers of forecasting errors. This does not mean that someone who based his predictions on correct praxeological reasoning would necessarily have to be a better predictor of future economic events than someone who arrived at his predictions through logically flawed deliberations and chains of reasoning. It means that in the long run the praxeologically enlightened forecaster would average better than the unenlightened ones.
It is possible to make the wrong prediction in spite of the fact that one has correctly identified the event “increase in the money supply” and in spite of one’s praxeologically correct reasoning that such an event is by logical necessity connected with the event “drop in the purchasing power of money.” For one might go wrong predicting what will occur to the event “demand for money.” One may have predicted a constant demand for money, but the demand might actually increase. Thus the predicted inflation might not show up as expected. And on the other hand, it is equally possible that a person could make a correct forecast, i.e., there will be no drop in purchasing power, in spite of the fact that he was wrongly convinced that a rise in the quantity of money had nothing to do with money’s purchasing power. For it may be that another concurrent change occurred (the demand for money increased) which counteracted his wrong assessment of causes and consequences and accidentally happened to make his prediction right.
However, and this brings me back to my point that praxeology logically constrains our predictions of economic events: What if we assume that all forecasters, including those with and without sound praxeological knowledge, are on the average equally well-equipped to anticipate other concurrent changes? What if they are on the average equally lucky guessers of the social and economic future? Evidently, we must conclude then that forecasters making predictions in recognition of and in accordance with praxeological laws like the quantity theory of money will be more successful than that group of forecasters which is ignorant of praxeology.
It is impossible to build a prediction formula which employs the assumption of time-invariantly operating causes that would enable us to scientifically forecast changes in the demand for money. The demand for money is necessarily dependent on people’s future states of knowledge, and future knowledge is unpredictable. And thus praxeological knowledge has very limited predictive utility. 
From the recognition of the fact that perfect foresight eliminates the very need of knowing and knowers, and that such a need only arises if, as in our world, foresight is less than perfect, and insofar as knowledge is a means of bringing about preferences, it does not follow that everything is uncertain. Quite to the contrary.
the idea of perfect or radical uncertainty (or ignorance) is either openly contradictory insofar as it is meant to say “everything about the future is uncertain except that there will be uncertainty-about this we are certain,” or it entails an implicit contradiction if it is meant to say everything is uncertain and that there is nothing but uncertainty, is uncertain, too.” (I do know such and such to be the case, and I do not know whether such and such is the case or not.) Only a middle-of-the-road position between the two extremes of perfect knowledge and perfect ignorance is consistently defensible: There exists uncertainty but this we know for certain. Hence, also certainty exists, and the boundary between certain and uncertain knowledge is certain (based on certain knowledge).
Hoppe continued (on uncertainty):
it cannot be ruled out categorically that we might be mistaken, and that the future will be so different from the past that all of our past knowledge will be entirely useless. It is possible that none of our instruments or machines will work anymore tomorrow, that our houses will collapse on top of us, that the earth will open up, and that all of us will perish. It is in this sense that our knowledge of the external physical world must be ultimately regarded as uncertain.
Hoppe continued (on knowledge):
Notwithstanding this ultimate uncertainty of our knowledge concerning the external world, however, as a result of contingent circumstances, the relative stability and regularity in the concatenation of external objects and events, it has been possible for mankind to accumulate a vast and expanding body of practically certain knowledge. This knowledge does not render the future predictable, but it helps us predict the effects to be produced by definite actions.
Hoppe continued (on radical uncertainty):
Much of our future is, practically speaking, perfectly certain. Every product, tool, instrument or machine represents a piece of practical certainty To claim, instead, that we are faced with radical uncertainty and that the future is to all of us unknowable is not only self-contradictory but also appears to be a position devoid of common sense.
Little of this ever attracts the attention of theoreticians of radical uncertainty. The existence of a practical working technology and of a vast and flourishing insurance industry constitutes an embarrassment for any theory of radical uncertainty. If pressed sufficiently hard, of course, Lachmann and his followers would probably admit the undeniable and, as if all of this did not matter, quickly move onto another problem.
Can we really believe that each successive socialist experiment requires a different explanation, and that it is impossible to say anything applicable to each and every form of socialism, so that as long as there exists no private ownership of the means of production, and hence no factor prices, economic calculation (cost-accounting) will be impossible and permanent misallocation (waste) will have to result? Can we really believe that, as long as socialism is not actually abolished, this proposition may no longer hold true, because agents can learn from experience and may no longer act in an identical fashion? Can we really believe that if a central bank were to double the paper money supply overnight, this would not, now and forever, lead to a drop in the purchasing power of money as well as a systematic income redistribution in favor of the central bank and the early receivers of the newly-created money at the expense of those receiving it later or not at all? Can we really believe that if the minimum wage were fixed today at one million dollars per hour and if this decree were strictly enforced and no increase in the money supply were to take place, this measure might not lead to mass unemployment and a breakdown of the division of labor because people can learn from experience?
To use a perfect analogy while it is true that I am unable to predict eveything that I will say or write in the future, this does not imply that I cannot predict anything about my future speaking and writing. I can predict, and indeed I can predict with perfect certainty, and regardless of whether I will speak or write in English or German, that, as long as I will speak or write at all, in any language whatsoever, all of my speaking and writing will have a constant and invariable logical (propositional) structure: that I must use identifying expressions, such as proper names, and predicators to assert or deny some specific property of the identified or named object, for instance. In the same way it holds that even though I cannot predict what goals I may pursue in the future, that means I will deem appropriate to reach these goals, and what other conceivable courses of action I will choose to reject in order to do what I will actually do (my opportunity cost), I can still predict that as long as I act at all, there will be goals, means, choices, and costs; that is, I can predict the general, logical structure of each and every one of my actions, whether past, present or future. And this is precisely what economic theory or, as Mises has termed it, praxeology, is all about: providing knowledge regarding actions as such and knowledge about the structure which any future knowledge and learning must have by virtue of the fact that it invariably must be the knowledge and learning of actors.
I may not be able to predict that I will engage in voluntary exchanges, when, what it is that will be exchanged, or the exchange ratio at which the goods or services in question will be traded, etc., because all of this may indeed be affected by my and others’ knowledge and change as this knowledge changes. But I can predict with perfect certitude that if a voluntary exchange takes place,regardless of where, when, what, and at what exchange ratio, both exchange partners must have had opposite preference orderings and must have expected to benefit from the exchange. No possible learning can ever change this. Likewise, I may not be able to predict that or when a socialist experiment will be undertaken or discontinued. Nor will I ever be able to predict such an experiment’s many specific features. All of this may be affected by learning. But regardless of whatever people may learn and how their learning may shape the peculiar shape of socialism, I can’still predict with absolute certainty that as long as one is in fact dealing with socialism, any and all economic calculation will be impossible and permanent misallocations of production factors must result because this consequence is already logically implied in what socialism is. Similarly, I may not be able to forecast that a money will actually come into existence, and it is certainly possible that mankind may one day revert back to barter. Nor can I predict with certainty what specific kind of money will be employed in the future. But I can predict with perfect certitude that if there is any money in use at all, an increase in its supply must lead to a reduction in its purchasing power below what it otherwise would have been. This follows simply from the definition of money as a medium of exchange.
Mises, Human Action:
Understanding is not a privilege of the historians. It is everybody’s business. In observing the conditions of his environment everybody is a historian. Everybody uses understanding in dealing with the uncertainty of future events to which he must adjust his own actions. The distinctive reasoning of the speculator is an understanding of the relevance of the various factors determining future events. And–let us emphasize it even at this early point of our investigations–action necessarily always aims at future and therefore uncertain conditions and thus is always speculation. Acting man looks, as it were, with the eyes of a historian into the future.
7. Praxeological Prediction
Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action. But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding.
We can predict, as will be shown later, that?–other things being equal?–a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop. This question can be answered only by understanding.
The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. Understanding, by trying to grasp what is going on in the minds of the men concerned, can approach the problem of forecasting future conditions. We may call its methods unsatisfactory and the positivists may arrogantly scorn it. But such arbitrary judgments must not and cannot obscure the fact that understanding is the only appropriate method of dealing with the uncertainty of future conditions.
Salerno: Mises and Hayek Dehomogenized:
For Mises, human action, whether isolated or involving monetary exchange, is always motivated by the eagerness of the actor to enhance his welfare and consists of choosing among alternative employments of resources whose necessarily future results are not known with certainty. Because the choice process logically implies uncertainty–choice and action would be obviously futile in a world where humans are predestined to endure a rigidly unchangeable sequence of future events known with perfect certainty–the prerequisite of any specific act of choice is the acquisition of knowledge, via direct experience or from other sources of information, about the events and prevailing circumstances of the recent past that may be relevant in formulating an “understanding” of the future conditions upon which the actions under consideration will impinge.
Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of the consumers.
Note Mises and the other Austrians are careful not to speak of knowledge of the (uncertain) future, but verstehen/understanding, judgment, anticipation, forecast.
to choose correctly does not mean that one has experienced all relevant data, but that one acts according to a correct judgment upon these data … Entrepreneurial appraisements of the factors of production do not presuppose information about the future. They are judgments based on estimates, that is, judgments about the future.
… the conditions of action are not immutable. Rather, they change from day to day. Here lies the problem of the application of past knowledge. We have to judge whether the same conditions will prevail in the future as well. To this task all our empirical knowledge is of no help. … No past experience tells us what we should expect for the future to come. Neither can it tell us which actions we should choose. … Each action presupposes an ingredient that is entirely distinct from knowledge and information, namely, a judgment upon the conditions prevailing in the future.
The market process is thus inextricably linked to choice and action. Knowledge and communication, on the other hand, are secondary.
(For additional, related quotes, see also my post Knowledge vs. Calculation.)
Henry Hazlitt, in his review of a Kirzner book:
It is not always true that the entrepreneur perceives an opportunity. He thinks he perceives it He perceives an apparent opportunity. In fact, he is betting on an assumed future condition. What he acts on may not be a perception but a guess. As Kirzner himself concedes, … , the entrepreneur’s action “must to some extent constitute a gamble.” … Every entrepreneur is pitting his own guess or ‘perception’ against the composite guess or perception of all the rest.