Theory and the facts of reality

By Dr Frank Shostak

According to the popular way of thinking, our knowledge of the economy is elusive. Consequently, the best that we can do is to attempt to ascertain some facts of economic reality by applying various statistical methods on the so-called macro data. 

For instance, an economist is of the view i.e. has a theory that consumers’ outlays on goods and services are determined by personal disposable income and the interest rate. (The personal disposable income and the interest rate according to the economist’ view are the driving variables of consumer outlays). 

By means of a statistical method, the economist then converts this view into an equation. The established equation in turn is employed in the assessment of the future direction of consumer outlays. If the equation generates accurate forecasts, then it is regarded as a good tool to ascertain the facts of reality. If it fails to produce accurate forecasts then it no longer helpful in the establishment of the facts of reality. In this case, the theory must be abandoned, or modified. The popularizer of this way of thinking 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. 

On this way of thinking, as long as the theory “works,” it is regarded as a valid framework as far as the assessment of economic conditions is concerned. According to Friedman, 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. (It does not matter whether consumer outlays are driven by disposable income and the interest rate only, or perhaps also by some additional other variables). In fact anything goes, as long as the theory can generate accurate forecasts.  

By 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.  

Thinkers such as Ludwig von Mises held a different view. For Mises,

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

According to Mises, in order to assess the facts of reality an economist must employ a theory, which is not derived from historical data as such. The theory must “stand on its own feet” independently of the historical data. Given that, individuals have a certain knowledge about themselves; this can assist in ascertaining such a theory. For instance, one can observe that individuals’ are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street or dining in restaurants. The distinguishing characteristic of these activities is that they are conscious and purposeful. 

Using the knowledge that human action is conscious and purposeful, we can establish the meaning of individuals conduct. 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. Individuals operate within a framework of means and ends; they use various means to secure ends.

The knowledge that individuals pursue purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. For instance, contrary to popular thinking, individual’s outlays on goods and services are not caused by 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. 

While it is true that individuals’ likely to 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 the consumption of goods and services.

The knowledge that human action is conscious and purposeful is certain and not tentative. Anyone who tries to object to this contradicts himself for he is engaged in a purposeful and conscious action to argue that human actions are not conscious and purposeful. 

Applying the means-end framework in the world of economics

Furthermore, the knowledge that individuals’ action is conscious and purposeful implies that it emanates from reality.  Various conclusions that are derived from this knowledge of conscious and purposeful conduct are valid as well.  According to Murray Rothbard,

Beginning with the certain knowledge of the basic explanatory axiom A, he deduces the implications of A: B, C, and D. From these he deduces further implications, and so on. If he knows that A is true, and if A implies B, C, and D, then he knows with certainty that B, C, and D are true as well.


We do not know, and may never know with certainty, the ultimate equation that will explain all electromagnetic and gravitational phenomena; but we do know that people act to achieve goals. And this knowledge is enough to elaborate the body of economic theory.

It also implies that this knowledge could help economists to make sense of observed activities of individuals. For instance, an individual is planning to acquire goods and services in order to fulfil a goal of sustaining his life and wellbeing. In order to attain the goal, the individual employs money to exchange for the goods and services. 

Since money originated from the most marketable commodity, we can also deduce that money is a general medium of exchange. Thus, the individual exchanges goods for money and then exchanges money for goods that he believes will support his life and wellbeing. We can also infer that the individual exchanges something for something with the help of money. 

Consider now the case of a counterfeiter that has generated money out of “thin air”. The counterfeiter secured the money by exchanging nothing for it. He then exchanges the money for goods and services. This means that the counterfeiter has exchanged nothing for something. What we have here that by means of the money out of “thin air” the counterfeiter diverts to himself wealth from wealth generators. Consequently, this weakens wealth generators ability to generate wealth. This in turn undermines the wealth generation process. Furthermore, we can infer from this that any organization or anyone that provides the platform for the engagement in the exchange of nothing for something undermines the wealth generation process.

In addition, we know that a price of a good is the amount of money paid for the good. We also know that for a given quantity of goods an increase in the money supply, all other things being equal, must lead to more money paid for a unit of the good – an increase in the prices of goods. 

Hence, without the increase in money supply, all other things being equal, it is not possible to have general increases in prices. We can also infer that increases in the growth rate of money out of “thin air’ give rise to activities that a free unhampered market would not support. Note that as long as the growth rate in the money out of “thin air” is rising, various activities that emerged on the back of the money out of “thin air” could flourish by diverting to themselves wealth from wealth generators.

Once the growth rate of money out of “thin air” declines, various activities that emerged as a result of the previous increase in money out of “thin air” are going to experience hard times. With a decline in the money growth rate, these activities now have less support – less real wealth is diverted to them from wealth generators. What we have here is a boom-bust cycle. Moreover, whenever money is injected, it starts with a particular market before it moves to other markets. There is a time lag. This in turn could provide us with an information about the future events – such as boom-bust cycles and price inflation. 

Applying the means-end framework in assessing interest rates 

For most individuals, maintaining their life and wellbeing is the ultimate goal. We know that to stay alive an individual must consume goods in the present. This means that the individual must prefer the consumption of an identical basket of goods at present rather than in the future. This also means that the individual assigns to the basket of goods in the present a greater importance than to the same basket of goods in the future. An individual that has just enough goods to keep him alive is unlikely to consider investing or lending some of his scarce goods. In this situation, he is expressing an unlimited preference to consuming goods at present versus consuming goods in the future. This means that he has expressed an unlimited time preference.  

As the pool of wealth is starting to increase, the individual is likely to consider investment and lending some of his wealth, all other things being equal. This means that the expanded pool of goods permits the individual to lower his time preference. Alternatively, we can say that the individual has lowered the premium he assigns to the present consumption versus the future consumption. The premium is what interest is all about. Observe, that through changes in interest rates individuals issue signals to businesses regarding their future requirements. An organization such as the central bank, which tampers with these signals, generates havoc in the economy for it causes businesses to disobey individuals’ instructions regarding their future consumption. 

Consider a case when various experts are advising the central bank to counter the rising momentum of the prices of goods and services by means of lifting interest rates. We suggest that lifting interest rates is not the right mean to counter the increase in the momentum of prices. We hold that this is going to undermine the wellbeing of individuals since raising interest rates amounts to tampering with market signals. In order to counter the increase in the prices momentum all that is required is to close the loopholes for the creation of money out of “thin air”. In this regard, a major loophole for the money creation out of “thin air” is the buying of assets by the central bank. Likewise, the lowering of interest rates is not a suitable mean to set in motion an economic growth. What is required is to free the economy and to allow businesses to get on with the task of wealth generation. 

Also, note that to stay alive implies that the interest rate must be positive. This emanates from the fact that in order to stay alive individuals must consume at present i.e. to have a positive time preference. Now, whenever, negative market interest rate is observed, this does not mean that the positive time preference theory is flawed. Most likely the observed contradiction is because of the central bank tampering with financial markets that caused the market interest rate to become negative. Note that this contradiction is resolved by means of a theory, which instructs that in order to stay alive the time preference interest rate has to be positive. 

Observe again that the final referee here is the theoretical framework and not the observed data. Only by means of a theory, the data can be explained. In this sense, the observed data by itself does not supply the facts of reality. Whenever commentators make comments about the data, they are employing a particular theory to make these comments. Hence, to establish the validity of their comments, a logical examination of the theories employed by commentators is required. Let us say that the central bank is engaging in an expansionary monetary policy. Many commentators consider this as necessary to promote economic growth and lift individuals’ well-beings. Careful scrutiny however, is going to reveal that within all other things being equal, an expansionary monetary policy must result in a weakening of the process of wealth generation and the weakening of the economy.


Without a theory that “stands on its own feet”, various mathematical and statistical methods cannot assist an analyst in establishing causes in the world of economics. All that these methods could do is to describe things. To ascertain the underlying causes, one requires a logically worked out theory. By means of such a framework, an analyst could identify the core factor that drives the economic variable of concern. Once the core factor was identified, the analyst should stick to it. Various non-core influences should be assessed with respect to the possible effect these influences have on the core factor. 

More from Dr Frank Shostak
Where is the US dollar heading against the Euro?
By Dr Frank Shostak The price of the Euro in terms of...
Read More
0 replies on “Theory and the facts of reality”