Assumptions in economics and the real world

By Dr Frank Shostak

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 these assumptions are not realistic, Krugman nonetheless argued that somehow his model could be useful in offering solutions to the economic crisis in Japan.

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,
A definition is a statement that identifies the nature of the units subsumed under a concept. It is often said that definitions state the meaning of words. This is true, but not exact. A word is merely a visual- auditory symbol used to represent a concept; a word has no meaning other than that of the concept it symbolizes, and the meaning of a concept consists of its units. It is not words, but concepts that man defines – by specifying their referents. The purpose of a definition is to distinguish a concept from all other concepts and thus to keep its units differentiated from all other existents.
Moreover says Rand,
The truth or falsehood of all of man’s conclusions, inferences, thought and knowledge rests on the truth or falsehood of his definitions.
The employment of assumptions in various economic models that are 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.
On this way of thinking, our knowledge of the world of economics is ambiguous. 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.

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.

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 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 also means that causes emanate from individuals.

The fact that individuals consciously pursue purposeful actions provides us with definite knowledge. This knowledge sets the base for a coherent framework that permits a meaningful assessment of the state of an economy.

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.
Observe that in physics, the ultimate assumptions cannot be verified directly, because we know nothing directly of the explanatory laws or causal factors.

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.

Various conclusions that are derived from this knowledge of conscious and purposeful action are valid as well, implying that there is no need to subject them to various laboratory tests as is done in the experimental economics. For something that is certain knowledge, there is no requirement for any empirical testing.

Now, the knowledge that people are acting purposefully permits 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” – 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. Note that an individuals’ demand is constrained by his ability to produce goods. The more goods that the individual can produce the more goods he can demand and acquire.

By most economic commentators, to counter an emerging economic slump the central bank should 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 Murray 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.

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. 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.”

Why arbitrary concepts and definitions undermine individuals’ well-beings?
The arbitrary process of forming assumptions in economics is not something that should be taken lightly. According to Rothbard,
But false assumptions are the reverse of appropriate in economics. For human action is not like physics; here, the ultimate assumptions are what is clearly known, and it is precisely from these given axioms that the corpus of economic science is deduced. False or dubious assumptions in economics wreak havoc.
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.

Arithmetically however, 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.

By following that, individuals pursue conscious and purposeful conduct we can suggest that in economics causes emanate from human beings. Consequently, in economics we do not assume we in fact know. 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.

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