Theory and curve fitting

By Dr Frank Shostak

By popular thinking, our knowledge of the world of economics is elusive – it is not possible to ascertain how the world of economics really works – hence it is held the criteria for the selection of a theory should be its predictive power. So long as the theory “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the theory breaks down, the search for a new theory begins. 

For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in the assessments of the future direction of consumer spending. If the theory fails to produce accurate forecasts, it is either replaced, or modified by adding some other explanatory variables. On this way of thinking the tentative nature of theories implies that 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 yield good predictions. 

 According to Milton 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. 

Why the predictive capability for accepting a model is questionable?  

The popular view that sets predictive capability as the condition for accepting a theory is questionable. Even the natural sciences, which mainstream economics tries to emulate, don’t validate their models this way. 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 an 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? 

Now, if the criteria for the acceptance of a theory is its forecasting ability, then it is possible to come up with all sorts of ideas that could have very good forecasting capabilities. Note that by means of quantitative methods it is possible to validate various ideas. For instance, one could establish that the income of a particular individual is well correlated with the overall income in the economy. This is called curve fitting. This idea or the model can then be used in forecasting the growth rate of GDP.

We hold that contrary to the popular way of thinking the criteria for selecting a model should not be its predictive ability but whether it is theoretically sound.  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.”  

Do we know something about ourselves?

Economic theory should be able to explain the essence of economic activity. Quantitative methods are of not much help in this regard. All that quantitative methods can do is just compare the movements of various historical pieces of information. These methods can describe but not explain. These methods cannot identify the driving factor of economic activity. 

Contrary to popular thinking, economics is not about the 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 promote individuals’ lives and well-being. 

One can observe that individuals are engaged in a variety of activities such as performing manual work, driving cars and dining in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.  

Thus, manual work may be a means for some individuals to earn money, which in turn enables them to achieve various goals such as buying food or clothing. Dining in a restaurant could be a means to establishing business relationships. Driving a car could be a means for reaching a particular destination. 

Individuals operate within a framework of means and ends – they are using various means to secure ends.  

Purposeful action implies that individuals assess or evaluate various means at their disposal against their ends. At any point in time, individuals may have an abundance of ends that they would like to achieve. What limits the attainment of ends is the scarcity of means. 

Hence, once more means become available, a greater number of ends, or goals, can be accommodated–i.e., individuals’ living standards will increase. 

Another limitation on reaching various goals is the availability of suitable means. Thus, to quell his thirst in the desert, an individual requires water. Diamonds in his possession will be of no help in this regard. 

The fact that individuals 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 decline in the demand for goods and services is observed. Are we then to conclude that the decline in the demand is the cause of an economic recession? 

We know that individuals persistently strive to improve their life and well-being hence their demand for goods and services is likely to be rising and not declining. Consequently, the decline in general demand is a result of individuals inability to support their demand. Problems on the production side, i.e., with the means, are the likely causes of an observed general decline in the 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. 

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 individual’s wellbeing is going to be protected. 

Money however, is not suitable 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.

The fact that man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors.  Thus, contrary to the popular thinking, the individual’s outlays on goods are not driven by real income as such. In his own unique context, every individual decides how much of a given real income will be used for consumption and how much for investments. 

Whilst it is true that individuals are likely to respond to changes in their incomes, the response is not automatic. Every individual assesses the change in real income against the particular set of goals he wants to achieve. He might decide that it is more beneficial to increase investment in financial assets rather than to raise consumption.  

Conclusion

By mainstream thinking the criteria for the selection of the “right” model i.e. the “right” theory should be its ability to make accurate forecasts. We hold that this way of thinking is questionable. We suggest that what matters is to have a theory that provides the essence of human activity. Once the essence is established, it is possible to make sense of the data. 

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