Why Economics Needs Good Theory: Facts and Figures Aren't Enough
Could historical data by itself serve as the basis for the factual assessments of the world of economics? It is believed that through the application of statistical methods on historical data, or just by gazing at the data, one could extract the facts of reality regarding the world of economics. But in order to really make sense of the data one must have a theory, which stands on its own feet, and did not originate from the data. By means of a theory, one could scrutinize the data and could then try to make sense out of it.
The key ingredient of such a theory is that it must originate from something real that cannot be refuted. A theory that rests on the foundation that human beings are acting consciously and purposefully fulfils this.
Contrary to popular thinking, economics is not about GDP, the CPI, or other economic indicators as such, but about human activities that seek to promote people's lives and well-being. One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.
Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals such as buying food or clothing. Dining in a restaurant could be a means to establishing business relationships. Driving a car could be a means for reaching a particular place. In other words, people operate within a framework of ends and means; they are using various means to secure ends.
Purposeful action implies that people assess or evaluate various means at their disposal against their ends.
At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated — i.e., people's living standards is going to increase.
Another limitation on reaching various goals is the availability of suitable means. Thus to quell my thirst in the desert, I require water. Diamonds in my possession will be of no help in this regard.
That human beings are acting consciously and purposefully cannot be refuted, for anyone that tries to do this does it consciously and purposefully i.e. he contradicts himself.
Ludwig von Mises, the founder of this approach, labelled it as praxeology. By stating that human beings act consciously and purposefully Mises was able to derive the entire body of economics.
Causes in economics originate from human beings
That man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors.
For instance, by looking at the data without a coherent framework of thinking one could fit any theory to provide an explanation of what the heart of economic growth is all about.
However, if we start from the fact that human beings are operating in the means-ends framework then one is likely to establish that without an expansion in the means of sustenance no sustainable expansion in economic growth is going to emerge.
In his framework of thinking, Mises was very precise in presenting the essence of the terms he employed. For Mises defining the terms was the key for successful analyses. For instance, his analysis of money begins by establishing the definition of money. To do that Mises started from the beginning — at the point where the world was in a state of direct exchange.
According to Mises the distinguishing characteristic of money, that it is the general medium of exchange. It has evolved from the most marketable commodity. On this he wrote,
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
Money is the thing that all other goods and services are traded for. This fundamental characteristic of money must be contrasted with other goods.
For instance, food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that in turn will permit the production of a larger quantity of goods and services.
Once the definition of money is established, we are now ready to explore the interactions between money and various parts in an economy.
Two Kinds of Economists
In mainstream economics there are two types of economists — in one camp, there are the so-called theoreticians, or "ivory-tower economists," who generate various imaginary models and use them to form an opinion on the world of economics.
In the other camp, we have the so-called "practical" economists, who derive their views solely from the data.
Whereas the ivory-tower economists are of the belief that the key to the secret of the economic universe is via abstract models, the "practical" economists hold that if one "tortures" the data long enough, it will ultimately confess and the truth will reveal itself.
Economic theory, however, must have only one purpose — to explain the essence of the subject matter of economics. However, statistical methods are of no help in this regard. All that various statistical methods can do is just compare the movements of various historical pieces of information. These methods cannot identify the driving forces of the world of economics.
Likewise, models that are based on economists' imaginations are not of much help either since these theories are not ascertained from the real world.
For example, in order to explain the economic crisis in Japan, the famous mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given.1 Whilst admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model could be useful in offering solutions to the economic crisis in Japan.
Using Data within the Context of Human Action
The knowledge that human actions are conscious and purposeful allows us to make sense out of historical data. According to Murray Rothbard,
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”.
To undertake the identification of a 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 life 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.
Data and Money Production
Alternatively, consider the situation in which the central bank announces that increasing money supply growth while price inflation is low could 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 mean to promote economic growth. In other words, the goal — of lifting real economic growth — cannot be achieved by means of printing money. On the contrary, we can establish that printing money is going to set in motion an exchange of nothing for something and thus the weakening in the wealth generating process.
The knowledge that people are pursuing purposeful actions also permits us to evaluate the popular way of thinking that holds that the "motor" of an economy is consumer spending — i.e., demand creates supply. We know, however, that without means, no goals can be met. However, means do not emerge “out of the blue” — they must be produced first. Hence, contrary to the popular thinking, the driving force is supply and not demand.
The fact that man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. Whilst it is true that people will respond to increases 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.
Data by itself cannot produce much information about the facts of reality without a theory that “stands on its own feet” and is not derived from the data.
Gazing at the data cannot assist an analyst in establishing causes in the world of economics. All that gazing will do is to help describe things. To ascertain the underlying causes one requires an explanation that can be made by a logically worked out theory.
The arbitrary nature of mainstream economics has given rise to the view that there is a gulf between theory and practice. There is no such thing as a good-but-not-applicable theory. A good theory is also an applicable one.
Economists and various other financial experts who derive their knowledge of the economy solely from statistical correlations of various historical data or from pure gazing at the data run the risk of misleading themselves and their audiences.
Likewise, economists who base their views on imaginary models are not in a position to say anything meaningful, and whatever they utter is just plain arbitrary.
- 1. See: Paul Krugman, "Japan’s Trap" May 1998 at Krugman’s website.