Why theory is the key in ascertaining the state of the economy?

By Dr Frank Shostak

Most economic commentators are of the view that historical data is the key in assessing the state of the economy. 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 establish the state of economic conditions. The so-called data that analysts are looking at is however 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.

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. The purpose of a theory is to establish the essence of the subject of investigation. 

According to Ayn Rand, a theory is a set of abstract principles purporting to be a correct description of reality or a set of guidelines for man’s actions. (See The Ayn Rand lexicon Edited by Harry Binswanger, a Meridian Book p 500). 

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. 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.

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. 

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. The fact that an individual is pursuing 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 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.

Conclusion

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. 

Such a theory 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 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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