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 believed that one can organize historical data through quantitative methods into a useful body of information, which in turn can serve as the basis for assessing 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 decreases in the unemployment rate trigger price inflation? To confuse the issue further, it has also been observed that price inflation is well-correlated with changes in money supply.

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. In this way of thinking, the criterion for the selection of a theory should be its predictive power. If the model (theory) “works,” it is regarded as a valid framework assessing the economy. 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 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, these models are dressed in sophisticated mathematics to make them look credible.

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, however, cannot ascertain the essence of economic activity. Quantitative methods can only compare the movements of 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 don’t come from the real world.

Contrary to popular thinking, economics is not about gross domestic product, the Consumer Price Index, or other economic indicators 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 like performing manual work, driving cars, walking, or dining in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.

Purposeful action implies that individuals assess the means at their disposal against their ends. At any point, people have an abundance of ends that they would like to achieve but are limited by the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated, increasing people’s living standards.

The Knowledge That Human Action Is Purposeful Helps to Make Sense of Data

To undertake the identification of data, one must reduce it to its ultimate driving force, which is purposeful human action. For example, during an economic slump, we observe a general decline in the demand for goods and services. Do we then conclude that the decline in demand causes the economic recession?

We know that people persistently strive to improve their lives. 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, or means, likely cause an observed general decline in demand.

Knowing that individuals pursue purposeful actions permits us to evaluate the popular way of thinking that holds that the “motor” of the economy is consumer spending—that is, demand creates supply. We know, however, that without means, no goals can be met. However, means do not emerge out of the blue; they must first be produced. 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, 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. While it is true that people 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, such as deciding that it is more beneficial for him to raise his investment in financial assets rather than to raise consumption.

That people pursue purposeful actions is always valid. Anyone attempting to suggest this is not true engages in contradiction since those that argue that human action is not purposeful are actually engaging in purposeful action.

Statistical analysis without establishing the meaning of a particular economic activity cannot tell us what is going on in the world of human beings. All the statistical analysis can do is to describe things; it cannot explain, however, 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 a Valid Criterion for Accepting a Model?

The popular view that claims that predictive capability is the criterion for accepting a model creates problems. For example, a theory employed to build a rocket stipulates certain conditions that must prevail for its successful launch. One is good weather. Would we then judge the quality of a rocket propulsion theory based on 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 are met, which 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 to 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 that 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, to explain the economic crisis in Japan, economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given. While 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.

Originally Posted at https://mises.org/

By Mises