In their economic analyses
economists utilize a range of statistical methods that vary from highly
complex models to a simple display of historical data. It is generally held
that by means of statistical correlations one can organize historical data
into a useful body of information, which in turn can serve as the basis for
assessments of the state of the economy. In short, it is held that through
the application of statistical methods on historical data, one can extract
the facts of reality regarding the state of the economy.
Unfortunately, things are not as
straightforward as they seem to be. For instance, it has been observed that
declines in the unemployment rate are associated with a general rise in the
prices of goods and services. Should we then conclude that declines in
unemployment are a major trigger of price inflation? To confuse the issue
further, it has also been observed that price inflation is well correlated
with changes in money supply. Also, it has been established that changes in
wages display a very high correlation with price inflation.
So what are we to make of all this?
We are confronted here not with one but with three competing
"theories" of inflation. How are we to decide which is the right
theory? According to the popular way of thinking, the criterion for the
selection of a theory should be its predictive power. On this Milton Friedman
wrote,
The ultimate goal of a positive
science is the development of a theory or hypothesis that
yields valid and meaningful (i.e., not truistic)
predictions about phenomena not yet observed.[1]
So long as the model (theory)
"works," it is regarded as a valid framework as far as the
assessment of an economy is concerned. Once the model (theory) breaks down,
we look for a new model (theory). For instance, an economist forms a view
that consumer outlays on goods and services are determined by disposable
income. Once this view is validated by means of statistical methods, it is
employed as a tool in assessments of the future direction of consumer
spending. If the model fails to produce accurate forecasts, it is either
replaced or modified by adding some other explanatory variables.
The tentative nature of theories
implies that our knowledge of the real world is elusive. Because it is not
possible to establish "how things really work," it does not really
matter what the underlying assumptions of a model are. In fact anything goes,
as long as the model can yield good predictions. According to Friedman,
The relevant question to ask about
the assumptions of a theory is not whether they are descriptively realistic,
for they never are, but whether they are sufficiently good approximation for
the purpose in hand. And this question can be answered only by seeing whether
the theory works, which means whether it yields sufficiently accurate
predictions.[2]
The popular view in economics that
sets predictive capability as the criterion for accepting a model is absurd.
Even the natural sciences, which mainstream economics tries to emulate, don't
validate their models this way. For instance, a theory that is employed to
build a rocket stipulates certain conditions that must prevail for its
successful launch. One of the conditions is good weather. Would we then judge
the quality of a rocket propulsion theory on the basis of whether it can
accurately predict the date of the launch of the rocket?
The prediction that the launch will
take place on a particular date in the future will only be realized if all
the stipulated conditions hold. Whether this will be so cannot be known in
advance. For instance, on the planned day of the launch it may be raining.
All that the theory of rocket propulsion can tell us is that if all the
necessary conditions hold, then the launch of the rocket will be successful.
The quality of the theory, however, is not tainted by an inability to make an
accurate prediction of the date of the launch.
The same logic also applies in
economics. We can say confidently that, all other things being equal, an
increase in the demand for bread will raise its price. This conclusion is
true, and not tentative. Will the price of bread go up tomorrow, or sometime
in the future? This cannot be established by the theory of supply and demand.
Should we then dismiss this theory as useless because it cannot predict the
future price of bread? According to Mises,
Economics can predict the effects
to be expected from resorting to definite measures of economic policies. It
can answer the question whether a definite policy is able to attain the ends
aimed at and, if the answer is in the negative, what its real effects will
be. But, of course, this prediction can be only "qualitative."[3]
Human Action
Is Central
Now, without the knowledge that
human actions are purposeful, it is not possible to make sense out of
historical data. On this Rothbard wrote,
One example that Mises liked to use in his class to demonstrate the
difference between two fundamental ways of approaching human behavior was in
looking at Grand Central Station behavior during rush hour. The
"objective" or "truly scientific" behaviorist, he pointed
out, would observe the empirical events: e.g., people rushing back and forth,
aimlessly at certain predictable times of day. And that is all he would know.
But the true student of human action would start from the fact that all human
behavior is purposive, and he would see the purpose is to get from home to
the train to work in the morning, the opposite at night, etc. It is obvious
which one would discover and know more about human behavior, and therefore
which one would be the genuine "scientist."[4]
The fact that people consciously
pursue purposeful actions provides us with definite knowledge, which is
always valid as far as human beings are concerned. This knowledge sets the
base for a coherent framework that permits a meaningful assessment of the
state of an economy.
To undertake the identification of
data, one is required to reduce it to its ultimate driving force, which is
purposeful human action. For instance, during an economic slump, a general
fall in the demand for goods and services is observed. Are we then to
conclude that the fall in the demand is the cause of an economic recession?
We know that people persistently
strive to improve their lives and well-being. Their demands or goals are thus
unlimited. The only way then for general demand to fall is via people's
inability to support their demand. In short, problems on the production side
— i.e., with means — are the likely causes of an observed general
fall in demand.
Alternatively, consider the
situation in which the central bank announces that increasing money supply
growth while price inflation is low can lift real economic growth. To make
sense of this proposition we must examine the essence of money. Money is the
medium of exchange. Being the medium of exchange, money can only facilitate
existing real wealth. It cannot create more wealth. Money cannot be used in
production. It cannot be used in consumption. Hence we can conclude that
printing money is not the right means to promote economic growth. In other
words, the goal — of lifting real economic growth — cannot be
achieved by means of printing money.
The fact that man pursues
purposeful actions implies that causes in the world of economics emanate from
human beings and not from outside factors. For instance, contrary to popular
thinking, individual outlays on goods are not caused by real income as such.
In his own unique context, every
individual decides how much of a given income will be used for consumption
and how much for investments. While it is true that people will respond to
changes in their incomes, the response is not automatic. Every individual
assesses the increase in income against the particular set of goals he wants
to achieve. He might decide that it is more beneficial for him to raise his
investment in financial assets rather than to raise consumption.
In contrast, analyses that rely
solely on statistical correlations are of limited help, because they are of a
mechanical nature. Hence comments made by various experts who rely on such
frameworks are arbitrary. All that these experts can do is repeat
already-known data — they can tell us nothing about the essence of
economic activity. In short, various statistical and mathematical methods are
a particular way of describing but not explaining events; they do not improve
on our knowledge of what causes the fluctuations in the data.
Summary and Conclusions
According to the popular way of
thinking, the criterion for the selection of a theory should be its
predictive power. So long as the model "works," it is regarded as a
valid framework to assess the state of an economy. If the model fails to produce
accurate forecasts, it is either replaced or modified. The tentative nature
of theories implies that our knowledge of the real world is elusive. Contrary
to the popular view, we hold that by means of a fundamental statement that
human actions are conscious and purposeful we can derive the entire body of
economics. Because the knowledge derived here is based on a fundamental, true
statement, this knowledge is not tentative and elusive but absolutely
definite. Consequently, we don't require various statistical methods here to
validate the economic theory, which is derived from the fact that human
actions are conscious and purposeful. Analysts who rely on statistical
methods to ascertain the facts of reality are running the risk of producing
erroneous analyses.
Notes
[1] Milton Friedman, Essays in Positive
Economics (Chicago: University of Chicago Press, 1953).
[2] Milton Friedman, ibid.
[3] Ludwig von Mises,
The Ultimate Foundation of Economic Science, p. 67.
[4] Murray N. Rothbard,
preface in Theory and History by Ludwig von Mises.
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