Why looking at the data without a theory cannot tell us much

 

For most so-called practical economists, information regarding the state of an economy is derived from the data. Thus if an economic statistic such as real gross domestic product or industrial production displays a visible increase this is labelled as indicative of a strengthening in the economy. Conversely, a decline in the growth rate is regarded as weakening. It seems that by looking at the data one can ascertain the status of economic conditions. Is this however, the case? Note that the so called data that analysts are looking at is a display of historical information.

 

According to Ludwig von Mises, in Human Action P 41-49

History cannot teach us any general rule, principle, or law. There is no means to abstract from a historical experience a posteriori any theories or theorems concerning human conduct and policies.

Also in the The Ultimate Foundation of Economic Science p 74, Mises argued that,

What we can “observe” is always only complex phenomena. What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.

 

Furthermore,

 

The historian does not simply let the events speak for themselves. He arranges them from the aspect of the ideas underlying the formation of the general notions he uses in their presentation. He does not report facts as they happened, but only relevant facts.

Hence, to make sense of the data there is the need to have a theory beforehand that will guide the analyst regarding the interpretation of the data.

 

Importance of defining the subject of investigation

The key in the analysis of data is to establish the subject of investigation. Once the subject is established, the next step is to establish the definition of the subject. The purpose of the definition is to ascertain the key factors that determine the subject of the investigation.

 

To establish a definition it is helpful to go back as far as one can to the point of time when a particular thing has emerged. For instance, when analyzing money supply we would go back to the point in time when a particular commodity started to assume the role of money. In the case of money, one would establish that people have established money in order to promote the trade of goods for goods.

 

A commodity that was selected as money enabled the most efficient exchange. Note that by establishing that money is the medium of the exchange we have also established that people paying for one good in terms of other goods with the help of money. Without establishing the definition of money, it is not possible to say anything meaningful about money and its role in human affairs.

 

So when an analyst raises an alarm on account of a strong increase in money supply what triggered this alarm is not just an increase in money supply as such but the definition that a price of a good is the amount of money per unit of a good.  By observing an increase in money supply one can infer that all other things being equal, more money will be spent per good i.e. prices of goods are going to increase.

 

Note that without the definition of the price of goods it will not be possible to say anything meaningful about the increase in money supply.

 

The definition that money is the medium of exchange enables us to establish that once it is injected there are always early and late recipients of money. We can also establish that once injected, money is employed by some individual to exchange for goods and services from another individual.

 

This enables us to ascertain that there is a time lag before the unit of money will reach the third individual and so on. This in turn enables us to infer that as a result of the time lag and the definition that a price of a good is the amount of money per good a change in the money supply is likely to have a lagged effect on various markets and in turn on prices of goods in these markets.

 

According to Mises in The Ultimate Foundation of Economic Science P 74

The data of history would be nothing but a clumsy accumulation of disconnected occurrences, a heap of confusion, if they could not be clarified, arranged, and interpreted by systematic praxeological knowledge.

We can also conclude that without a theoretical framework the data cannot tell us the conditions of the economy so to speak. It cannot tell us whether the strong GDP data is on account of wealth expansion or on account of the erosion of the wealth generation process.

 

Now once we ascertain that loose monetary policies of the central banks are behind the so called strong economic conditions then by means of a theory we can establish that this is going to weaken the wealth generation process. We could then conclude that loose monetary policy would be bad news for the well-beings of individuals in the months ahead.

 

How useful are metaphors in clarifying what is going on in an economy?

Some commentators employ various metaphors to make sense of the data. For instance, the value of various transactions is lumped under the label of “economy”, which in turn is seen as following a trajectory in similarity to a space ship.

 

If the economy i.e. the space ship deviates from a trajectory that was established by central bank economists as the ideal trajectory, then it is the role of the central bank decision makers to introduce necessary policies to bring the economy back onto the desired trajectory.

 

Information regarding the current trajectory and it deviation from the ideal is obtained from assessing data such as GDP, industrial production, the consumer price index, the unemployment rate etc.

 

Observe, that the theory that policy makers are employing is derived from the view that the economy could be seen as a space ship that should follow a trajectory established by central bank policy makers.

 

If however we were to accept that so called economic activity is about the interaction of various individuals, and that the so called total output is not produced by the collective but by various individuals and that the production of the total output is not supervised by a supreme commander, then our interpretation of the data is going to differ from the central bank policy makers.

 

Our definition of money supply is also likely to assist us in clarifying that increases in money supply in order to place the economy on the trajectory stipulated by central authorities could in fact undermine the process of wealth formation. By striving to achieve the desired target, policies that are aiming at achieving these desired goals are going to undermine the life and wellbeing of various individuals in a given country.

 

Hence, various metaphors that are detached from the valid definition of the subject of investigation could in fact be detrimental to individuals’ wellbeing when policy makers are trying to make sense of the data.

 

We suggest that irrespective of the sophistication of the tools employed in the analysis of the data if the underlying definition is flawed then the results of the data analysis are going to be misleading.

 

The popular approach of setting a hypothesis and then testing it by means of various sophisticated tools is no different than data torturing to proof the case – torture the data until the data is going to confess.

 

For instance, an analyst speculates that the dog barking could be useful in verifying the phenomena of boom- bust cycle. If a dog barks, four times, it is indicative of an economic boom ahead and if the dog barks two times it is indicative of an economic bust.

 

By means of sophisticated statistical and mathematical methods, the analyst manages to prove the hypothesis. Should we take such results seriously?

 

As ridiculous as it may sound, famous economist Milton Friedman used a guitar string analogy to explain boom-bust cycles. If the string pushed strongly down it is likely to come strongly up once the downward pressure is removed. Based on this Friedman concluded that strong economic bust is going to follow by a strong economic boom. Various sophisticated mathematical tools seemed to support this hypothesis.

 

This is what one could get once we dismiss the establishment of a rigorous theory and replace it with a framework as suggested by Milton Friedman that anything goes as long as one could match the hypothesis with the data. 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]

Furthermore 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]

We suggest that without a properly thought out framework Friedman’s theory of a boom-bust cycle is as ridiculous as the dog barking theory of a boom-bust cycle and no sophisticated mathematical framework is going to make Friedman’s theory valid. What Friedman’s theory lacks is a valid definition of what boom-bust cycle is all about.

 

[1] Milton Friedman, Essays in Positive Economics, Chicago: University of Chicago Press, 1953.

[2] Milton Friedman, ibid,