Can data by itself inform us about the real world?

By Dr Frank Shostak

In order to make the data “talk,” economists utilize a range of statistical methods that vary from highly complex models to a simple display of historical data. It is generally held that by means of quantitative methods one can organize an historical data into a useful body of information, which in turn can serve as the basis for the assessments of the state of the economy. 

Now, it has been observed that declines in the unemployment rate are associated with a general rise in the prices of goods and services. Should we then conclude that declines in the unemployment rate are a major trigger of price inflation? To confuse the issue further, it has also been observed that price inflation is well correlated with changes in money supply. 

So what are we to make out of all this? How are we to decide which is the right theory? According to Milton Friedman we cannot know the facts of reality. On this way of thinking the criterion for the selection of a theory should be its predictive power. 

So long as the model (theory) “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the model (theory) breaks down, we look for a new model (theory). If the model fails to produce accurate forecasts, it is modified by adding some other explanatory variables. By this way of thinking anything goes, as long as the model can yield good predictions. 

Two Kinds of Economists 

The view that we can never be certain about anything, has given rise to two groups of economists. In the one camp, there are the so-called theoreticians, or “ivory-tower economists,” who generate various imaginary models and use them to form an opinion on the world of economics. As a rule, in order to appear to carry credibility these models are dressed in sophisticated mathematics. 

In the other camp, we have the so-called “practical” economists, who derive their views solely from the data. The “practical” economists hold that if one “tortures” the data by means of quantitative methods long enough, it will ultimately confess and the truth will reveal itself.

Quantitative methods are of no help to ascertain the essence of economic activity. All that various quantitative methods can do is just compare the movements of various historical pieces of information. These methods cannot identify the driving forces of economic activity. Likewise, models that are based on economists’ imaginations are not of much help either since these theories are not ascertained from the real world.

Contrary to popular thinking, economics is not about the GDP, the CPI or other economic indicators as such, but about human activities that seek to promote people’s lives and well-being. One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.

Purposeful action implies that individuals assess various means at their disposal against their ends. At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated i.e. people’s living standards will increase. 

The knowledge that human action is purposeful helps to make sense of data

To undertake the identification of data, one is required to reduce it to its ultimate driving force, which is purposeful human action. 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 demand is the cause of an economic recession? 

We know that people persistently strive to improve their life and well-being. Their demands or goals are thus unlimited. It is quite likely that the fall in people’s general demand is because of their inability to support their demand. Problems on the production side, i.e., with means, are the likely causes of an observed general decline in demand.

The knowledge that individuals are pursuing purposeful actions permits to evaluate the popular way of thinking that holds that the “motor” of the economy is consumer spending–i.e., demand creates supply. We know, however, that without means, no goals can be met. But means do not emerge out of the blue; means must be produced first. Hence, contrary to popular thinking, the driving force is supply and not demand.  

The fact that man pursues 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 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 investment. 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 for him to raise his investment in financial assets rather than to raise consumption. 

Observe that the knowledge that people pursue purposeful actions is not tentative it is always valid. Any one attempting to suggest that this is not the case is engaging in contradiction since those that argue that human action is not purposeful are in fact engaging in purposeful action. 

Pure statistical analysis without establishing the meaning of a particular economic activity cannot tell us the essence of what is going on in the world of human beings. All that the statistical analysis of the data can do is to describe things it cannot explain why people are doing what they are doing. 

Without the knowledge that human actions are purposeful, it is not possible to make sense out of historical data..

Is predictive capability valid criterion for accepting a model?

The popular view that sets predictive capability as the criterion for accepting a model is problematic. 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 the 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? 

Fanciful Assumptions   

The assessments, which are based on “purely” theoretical models, which derive their foundation from economists’ imaginations are likely to be detached from the facts of reality. A model, which is not derived from reality, cannot possibly explain the real world. 

For example, in order to explain the economic crisis in Japan, a mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given. Whilst admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model can be useful in offering solutions to the economic crisis in Japan.

Conclusion  

Popular economics asserts that because we cannot know the essence of economic reality, then in order to find out what is going on in the real world, we should rely on models that produce accurate predictions. We suggest that to be applicable, an economic theory must emanate from the essence of what drives human conduct. We suggest that the essence is purposeful action. 

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