The importance of assumptions in economics

By Dr Frank Shostak

Various assumptions employed by economists in their models appear to be of an arbitrary nature. The assumptions seem to be detached 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. 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.[1]

The employment of assumptions in various economic models that do not comply with the real world i.e. detached from the facts of reality is inspired by the writings of Milton Friedman.  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]

On this way of thinking, our knowledge of the world of economics is elusive. Since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. In fact anything goes, as long as the theory can generate accurate predictions.  

We suggest that a framework that sets predictive capability as the condition for accepting a theory is questionable.  

Is predictive capability a valid condition for accepting a theory?

The popular view that sets predictive capability as the condition for accepting a theory is problematic. 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 will hold, then the launch of the rocket will be successful. The quality of the theory, however, is not tainted by the 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]

In his Philosophical Origins of Austrian Economics (Mises Institute Daily Articles June 17 2006), David Gordon wrote that Bohm Bawerk maintained that concepts employed in economics must originate from the facts of reality and they need to be traced to their ultimate source. If one cannot trace it, the concept should be rejected as meaningless.  

Similarly, Ayn Rand has suggested that concept formation is not something arbitrary. The role of concepts is to integrate relevant existents whilst the role of definitions is to identify the essence of the existents of a concept. According to Rand,

The truth or falsehood of all of man’s conclusions, inferences, thought and knowledge rests on the truth or falsehood of his definitions.[4]  

Do we know something about ourselves?

Contrary to popular thinking, economics is not about gross domestic product (GDP), the consumer price index (CPI) or other economic indicators as such, but about human beings that interact with each other. It is about activities that seek to promote people’s lives and well-being.  

For instance, one can observe that people are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street or dining in restaurants. The essence of these activities is that they are purposeful.

Furthermore, we can establish the meaning of these activities. Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals like buying food or clothing. Dining in a restaurant can be a means for establishing business relationships. Driving a car may be a means for reaching a particular destination.

The knowledge that human actions are purposeful also implies that they are conscious. This in turn allows making 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”[5]

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.

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 strive to improve their life and well-being hence their demand for goods and services is likely to be rising and not declining. It is then probable that the decline in general demand is because of people’s inability to support their demand.

Problems on the production side, i.e., with means, are the probable causes of an observed general fall in demand. Once we have established that the likely causes of the economic slump are associated with supply factors, we can proceed to assess the possible reasons behind this.

The knowledge that people are acting purposefully also permits us to evaluate the popular mainstream view 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” – some of the means such as tools and machinery must be produced first. Hence, contrary to the popular thinking, the driving force is supply and not demand.

Or, for example, to counter an emerging economic slump various experts urge the central bank to increase the pace of monetary pumping. By means of an increase in the money supply growth rate it is held an individual’s wellbeing is going to be protected.

Money however, is not suitable as such to promote real wealth generation as it can only fulfil the role of the medium of the exchange. On the contrary, an increase in the supply of money is going to undermine the wealth generation process and will set in motion the menace of the boom-bust cycle. 

According to Rothbard,

Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.[6]

Why arbitrary concepts and definitions undermine individuals’ well-beings?   

The arbitrary process of forming concepts and definitions in economics is not something that should be taken lightly. For instance, one of the mandates of the central bank is to pursue a policy that is aiming at stabilizing the price level. 

The price level is seen as a weighted average of the prices of various goods and services. From this one can also infer that the average purchasing power of money is a weighted average of the purchasing power of money with respect to various goods and services.

It is however not possible to add up the purchasing power of money with respect to various goods and services in order to obtain the average purchasing power. Arithmetically one cannot add up different goods in order to establish the average purchasing power of a unit of money with respect to different goods.  

For instance, the purchasing power of a unit of money is established in the market as two potatoes and one loaf of bread.  Arithmetically one cannot add up two potatoes to one loaf of bread in order to establish the average purchasing power of a unit of money with respect to bread and potatoes.  

If we cannot ascertain what something is obviously, it is not possible to keep it stable. A policy that is aiming at stabilizing a fiction can only lead to a disaster.

Also, if one defines that inflation is about changes in the prices of goods and services whilst ignoring that the valid definition of inflation is changes in the money supply one is likely to set in motion policies that are damaging the economy rather than riding it from the menace of inflation.

Conclusion

Following the view that the facts of reality in economics are elusive, most economists have adopted the framework of Milton Friedman for validating economic theories.

On this framework, since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. In fact anything goes, as long as the theory can generate accurate predictions.  

We suggest that a theory that is based on assumptions that are detached from the facts of reality cannot be made valid because it generated accurate predictions during a particular time interval. Predictions by means of such theory must be viewed with skepticism.


[1] Paul Krugman, Japan’s Trap May 1998 in Krugman’s website.

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

[3] Ludwig von Mises, The Ultimate Foundation of Economic Science, p 67.

[4] Ayn Rand Introduction to Objectivist Epistemology – expanded second edition p 49

[5] Murray N. Rothbard preface in Theory and History by Ludwig von Mises.

[6] Murray N. Rothbard, Man, Economy and State, (Los Angeles: Nash Publishing, 1970) p. 670.

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