Without valid theory, the knowledge of the world of economics is not possible

By Dr Frank Shostak

According to popular thinking, it is held that by means of statistical and mathematical methods one can organize an historical data into a useful body of information. This in turn can serve as the basis for the assessments of the state of the economy. It is also held that the reality is elusive. Hence, it is not possible to know its true nature.

Some scholars such as Milton Friedman held that since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory employed to ascertain the facts of reality are. In fact anything goes, as long as the theory can yield good predictions. Other theorists such as Ludwig von Mises held that various pieces of data utilized by economists in their analysis is an historical display, which by itself cannot provide the economists with the facts regarding the real world.   According to Mises,

Experience of economic history is always the experience of complex phenomena. It can never convey knowledge of the kind the experimenter abstracts from a laboratory experiment.

Economists do not just randomly arrange the data before starting an analysis. On this Mises wrote,

The arrangement of various price data in groups and the computation of averages are guided by theoretical deliberations, which are logically and temporally antecedent.


It is vain to search for coefficients of correlation if one does not start from a theoretical insight acquired beforehand.

It seems that to make sense of the data economist must have a theory, which stands on its own feet, and did not originate from the data as such. The purpose of a theory is to establish the essence of the subject of investigation.  In his Philosophical Origins of Austrian Economics (Mises Institute Daily Articles June 17 2006), David Gordon writes that Bohm Bawerk maintained that concepts employed in economics must originate from the facts of reality – they need to be traced to their ultimate source. 

A theory that rests upon the idea that human beings are acting consciously and purposefully fulfils this criteria. 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 initiator of this approach labelled it praxeology. According to Rothbard,

But while most things have no consciousness and therefore pursue no goals, it is an essential attribute of man’s nature that he has consciousness, and therefore that his actions are self-determined by the choices his mind makes.

The knowledge that human actions are conscious and purposeful allows one to make sense of an historical data. According to 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”.  

Why methods of natural sciences not applicable in economics 

Most economists are of the view that the introduction of the methods of natural sciences such as laboratory experiments could lead to a major break-through in our understanding of the world of economics. According to Rothbard, 

This methodology, briefly, is to look at facts, then frame ever more general hypotheses to account for the facts, and then to test these hypotheses by experimentally verifying other deductions made from them. But this method is appropriate only in the physical sciences, where we begin by knowing external sense data and then proceed to our task of trying to find, as closely as we can, the causal laws of behavior of the entities we perceive. We have no way of knowing these laws directly; but fortunately we may verify them by performing controlled laboratory experiments to test propositions deduced from them. In these experiments we can vary one factor, while keeping all other relevant factors constant. Yet the process of accumulating knowledge in physics is always rather tenuous; and, as has happened, as we become more and more abstract, there is greater possibility that some other explanation will be devised which fits more of the observed facts and which may then replace the older theory. 

In contrast,

…. while a laboratory experiments are valid in the natural sciences, it is not so in economics. In the study of human action, on the other hand, the proper procedure is the reverse. Here we begin with the primary axioms; we know that men are the causal agents, that the ideas they adopt by free will govern their actions. We therefore begin by fully knowing the abstract axioms, and we may then build upon them by logical deduction, introducing a few subsidiary axioms to limit the range of the study to the concrete applications we care about. Furthermore, in human affairs, the existence of free will prevents us from conducting any controlled experiments; for people’s ideas and valuations are continually subject to change, and therefore nothing can be held constant. The proper theoretical methodology in human affairs, then, is the axiomatic-deductive method. The laws deduced by this method are more, not less, firmly grounded than the laws of physics; for since the ultimate causes are known directly as true, their consequents are also true.

Again, a laboratory is necessary in physics, for there a scientist can isolate various particles relating to the object of inquiry. 

Whilst the scientist can isolate various particles he does not, however, know the laws that govern these particles. All that he can do is hypothesize regarding the “true law” that governs the behaviour of the various particles identified. He can never be certain regarding the “true” laws of nature. 

According to Mises,

The physicist does not know what electricity “is”. He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process.

To appear scientific mainstream economists employ various quantitative methods. Thinkers such as Murray Rothbard had serious misgivings on the usage of quantitative methods in economics. On this Rothbard wrote that,

Not only measurement but the use of mathematics in general in the social sciences and philosophy today, is an illegitimate transfer from physics. In the first place, a mathematical equation implies the existence of quantities that can be equated, which in turn implies a unit of measurement for these quantities. Second, mathematical relations are functional; that is, variables are interdependent, and identifying the causal variable depends on which is held as given and which is changed. This methodology is appropriate in physics, where entities do not themselves provide the causes for their actions, but instead are determined by discoverable quantitative laws of their nature and the nature of the interacting entities. But in human action, the free-will choice of the human consciousness is the cause, and this cause generates certain effects. The mathematical concept of an interdetermining “function” is therefore inappropriate. Indeed, the very concept of “variable” used so frequently in econometrics is illegitimate, for physics is able to arrive at laws only by discovering constants. The concept of “variable” only makes sense if there are some things that are not variable, but constant. Yet in human action, free will precludes any quantitative constants (including constant units of measurement). All attempts to discover such constants (such as the strict quantity theory of money or the Keynesian “consumption function”) were inherently doomed to failure.

Again, contrary to the natural sciences, the factors pertaining to human action cannot be isolated and broken into their simple elements. However, in economics we know that human beings are acting consciously and purposefully. This knowledge in turn could help us to understand the world of economics.

For instance, a key role of money is to fulfil the role of the medium of exchange. An individual exchanges goods for money and then exchanges money for the goods of another individual. What we have here is an exchange of something for something.

In the modern world of the fiat money standard, we know that an increase in money supply results in an exchange of nothing for something. It leads to a diversion of wealth from wealth generators to non-wealth generating activities. This is certain knowledge and does not require empirical verification by a scientific analysis. We also know that for a given amount of goods an increase in money supply, all other things being equal, must lead to more money paid for a unit of a good –an increase in the prices of goods. (Note a price is the amount of money per unit of a good).

The complexity of the interaction of various factors means that there is no way for us to know the importance of each factor at any given point in time. Nonetheless, certain things such as changes in money supply, because it influences the prices of various goods with a time lag  could provide us with a useful information regarding events  such as the boom-bust cycles and changes in the price indexes in the months ahead. 

The fact that a man is pursuing purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. This means that mathematical methods are not going to be of much help here. For instance, contrary to popular thinking, individual’s 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. Whilst 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 to him to raise his investment in financial assets rather than to raise his consumption.


Reliance on an historical data as a foundation for the formation of a view about the state of the economy could be problematic. For the data 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. 

Once the theory passes the test of logic, it becomes a tool for the establishment of the facts of reality through the assessment of the historical data. 

Various mathematical and statistical methods cannot assist an analyst in establishing causes in the world of economics. All that these methods can do is to describe things. To ascertain the underlying causes one requires a logically worked out theory. 

After a logical scrutiny once, it is established that the theory faithfully describes the essence of the world of economics; one can start employing the theory in extracting the facts of reality from the historical data. Because the theory was not derived from the historical data as such, it can be utilized to also ascertain reasons for the discrepancy between the data and the theory. 

For instance, according to the economic theory individuals assign a greater importance to the consumption of goods at present versus the consumption in the future. This preference emanates from the fact that in order to maintain their lives and wellbeing people have to consume at present rather than in the future. On this way of thinking, the interest rate cannot be negative. If however, we do observe negative interest rates this discrepancy versus the theory raises the likelihood that a possible reason for this is the central bank monetary policies. 

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