Importance of a theory in economics


It is a common belief that sound economics must be based on facts and not on theoretical reasoning as such. Some commentators are dismissive of economic analysis which is not derived from the true data. For instance, some of commentators might suggest that although a theory employed by an analyst appears to be elegant it is nonetheless useless since it is not describing the facts of reality as depicted by historical data. The use of the free market economy framework without the central bank and government intervention, with businesses as a foundation to derive valid conclusions, is dismissed as nonsensical. After all, we don’t have a free market economy as such without a central bank and without government intervention.  In order to be practical, it is held, economists should stick to the facts.


Can the state of an economy be established using historical data?

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, truly 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 pp. 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.


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 to the analysis of data is to establish the subject of investigation. Once the subject is established, the next step is to define that 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 started to use 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 individuals are 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 knowledge that the price of a good is the amount of money per unit of that 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. the prices of goods are going to increase.


Note that without the definition of the price of a good it will not be possible to say anything meaningful about the increase in money supply and its effect on the prices of those goods.


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 individuals to exchange for goods and services from other individuals.


This enables us to ascertain that there is a time lag before the unit of money will reach subsequent  individuals, and so on. This in turn enables us to infer that because of the time lag and 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 in terms of the 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. 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 have ascertained 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 by setting an exchange of nothing for something. 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 guided missile.


If the economy, i.e. the guided missile, 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, 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 guided missile 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 so-called total output is not produced by the collective but by various individuals and that the production of total output is not supervised by a supreme commander, then our interpretation of the data is going to differ from that of 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 lives and wellbeing of various individuals in a given country.


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


Employing free market framework to assess the state of the economy

Does it make sense to employ the framework of a free market to assess the state of a hampered economy? We suggest that by means of a free market framework one can ascertain the problematic issues of the so-called real world. For instance, by means of the free market framework, we can ascertain the damage caused to individuals life and wellbeing by government policies of lockdowns to counter the coronavirus.

In a proper free market economy with a total separation of the economy and state, every company is on its own. Every company would have to figure out how to survive the damage caused by the coronavirus. In a free market environment, various businesses most likely would have savings for “difficult times” or they would have insurance for major shocks.


Furthermore, the free market environment is always subject to various shocks either positive or negative in nature. For instance, the implementation of new ideas and the introduction of new products is likely to be a shock to businesses that were too slow to adapt to these changes. The introduction of electricity was a shock for the manufacturers of candles and gas lights. For them to survive they had to adjust to the new environment. Likewise, the shock from the coronavirus has altered the environment where most businesses were operating. In a free market, businesses would have to adjust to the new setup.


They would have to figure out how to coexist with the virus. Various firms would emerge to counter the damaging effects of the virus on the lives and well-beings of individuals. It is highly unlikely that businesses would practice passivity by introducing lockdowns. On the contrary, they would confront the new environment and would try to make the best out of it – indeed they would need to in order to survive.


In an unfree market economy, which is hampered by government and central bank interference, businesses are not allowed to effectively counter the side-effects of the coronavirus. The lockdowns to counter the virus are in fact paralyzing businesses without allowing the generation of an effective way of countering the side-effects of the virus.


What further aggravates the damage inflicted by the lockdowns is the massive monetary pumping by the central bank to prevent the bankruptcy of various companies. Should the government and the central bank provide support to various companies?


Many people are sympathetic to the idea that the government and the central bank should provide support to businesses in order to keep them alive. However, neither the government nor the central bank are real wealth generating entities. Consequently, they are not in a position to provide any help as such. All that they can do is to take from one individual and give it to another individual.  By what criteria is the government going to decide how much to take from A in order to give to B?

Likewise, when the central bank embarks on aggressive monetary pumping to reduce liquidity difficulties of various businesses, this sets in motion the transfer of real savings from wealth generators to the holders of the newly injected money. This undermines the process of real wealth generation and subsequently weakens the foundations of the economy.


Additionally, the government and the central bank’s interference prevents the adjustment of businesses to the new environment caused by the coronavirus.


Note that all these conclusions were derived with the help of the employment of the free market framework.


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