Economic Models vs. The Real World

By Frank Shostak

The government’s releases of various economic indicators such as GDP, CPI and unemployment receive wide coverage in the media. In a measured and authoritative voice, various economists and other experts who are interviewed discuss their views regarding the health of the economy. A rise in an indicator such as GDP is interpreted as good news while a decline is seen as pointing to troubles ahead.

What are the tools that economists and financial experts utilize in their assessments of the economy? What is the basis of their framework of thought?

Making the Data Talk

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 statistical correlations one can organize 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. It is held that through the application of statistical methods on historical data, one can extract the facts of reality regarding the state of the economy.

Unfortunately, things are not as straightforward as they seem to be. For instance, 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. In addition, it has been established that changes in wages display a very high correlation with price inflation.

So what are we to make out of all this? We are confronted here with not one, but three competing “theories” of inflation. How are we to decide which is the right theory? According to the popular way of thinking, which was popularized by 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. According to Friedman,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed.1

Is Everything Uncertain?

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).

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 assessment of the future direction of consumer spending. If the model fails to produce accurate forecasts, it is modified by adding some other explanatory variables.

The tentative nature of theories implies that our knowledge of the real world 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 model are. In fact anything goes, as long as the model 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.2

Again, on this way of thinking, “anything goes,” what matters is to have a model that generates accurate predictions.

Two Kinds of Economists

The view that our knowledge is tentative and 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. Whereas the ivory-tower economists are of the belief that the key to the secret of the economic universe is via abstract models, the “practical” economists hold that if one “tortures” the data long enough, it will ultimately confess and the truth will reveal itself.

Economic theory, however, must have only one purpose — to explain the essence of economic activity. However, statistical methods are of no help in this regard. All that various statistical 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 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.

Thus, manual work may be a means for some people 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 place. People operate within a framework of ends and means; they are using various means to secure ends.

Purposeful action implies that people assess or evaluate 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 fall in the demand for goods and services is observed. Are we then to conclude that the fall in demand is the cause of an economic recession?

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, spending on goods is 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 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. On this Rothbard wrote,

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.”3

Is the Predictive Capability a 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? 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.”4

The fact that people 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 meaningful assessments of the state of an economy. In contrast, analysis that rely solely on statistical correlations is likely to be problematic. So-called pure statistical analysis can tell us very little about the essence of economic activity.

Fanciful Assumptions

Similarly, we must reject comments that are based on “purely” theoretical models, which derive their foundation from economists’ imaginations that are 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, the famous mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given.5 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

To be applicable, an economic theory must emanate from the essence of what drives human conduct. The key factor here is purposeful action, and the knowledge that people pursue purposeful actions permits an analyst to make sense of economic data.

• 1. Milton Friedman, Essays in Positive Economics, Chicago: University of Chicago Press, 1953.
• 2. Milton Friedman, ibid.
• 3. Murray N. Rothbard, preface in Theory and History by Ludwig von Mises.
• 4. Ludwig von Mises, The Ultimate Foundation of Economic Science, p 67.
• 5. Paul Krugman, “Japan’s Trap,” May 1998 at nytimes.com.

Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

This article was sourced from Mises.org

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