What Is the Purpose of Economic Theory?

by
Frank Shostak
My articles My booksMy videos
Follow on:

Mainstream economists believe our knowledge of the world of economics is elusive, so the criteria for choosing a theory should be its predictive power. If the theory “predicts,” it is regarded as a valid framework to assess the economy. Once a theory fails in that role, the search for a new theory begins.

For instance, an economist believes that consumer outlays on goods and services are determined by disposable income. Once this view is validated by statistical methods, it is used to assess 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. This way of thinking implies that our knowledge of the world of economics is elusive.

Since we cannot establish “how things really work,” then the underlying assumptions of a theory don’t matter. 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 Is the Predictive Capability for Accepting a Model Questionable?

Declaring 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 example, a theory used to build a rocket stipulates certain conditions that must prevail for its successful launch.

One of the conditions is good weather. Would we judge the quality of a rocket propulsion theory on whether it can accurately predict the date of the launch? 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.

Something like this cannot be known in advance. For instance, it may rain on the planned launch day. The rocket propulsion theory tells us that if all the necessary conditions hold, the rocket launch will be successful. The quality of this theory, however, is not tainted by an inability to make an accurate prediction of the launch date.

The same logic also applies in economics. We can say confidently, all other things being equal, that an increase in the demand for bread will raise its price. This conclusion is true, not tentative. But will the price of bread go up tomorrow, or in the future? This cannot be established by theories of supply and demand. Should we then dismiss these theories as useless because they cannot predict the future price of bread?

If the criterion for accepting a theory is its forecasting ability, then it is possible to come up with ideas that could have good forecasting capabilities. Quantitative methods would make it possible to validate these ideas. For example, one could establish that a person’s income is well correlated with the overall income in the economy, which is called curve fitting. This model can then be used to forecast gross domestic product growth rate.

Contrary to this popular way of economic thinking, a model should not be selected on its predictive ability but rather on its theoretical soundness. According to Ludwig von 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 economic activity. Quantitative methods are unhelpful because they only compare the movements of historical pieces of information. These methods can describe but not explain, nor can they identify the driving factor of economic activity.

Contrary to popular thinking, economics is not about gross domestic product, the consumer price index, or other economic indicators; it is about how human beings interact with one another. It is about their activities promoting their lives and well-beings.

People engage in 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 enables them to achieve goals such as buying food or clothing. Dining in a restaurant could be a means to establish business relationships, while driving a car is a means for reaching a destination.

Individuals operate within a framework of means and ends, using various means to secure ends. Purposeful action implies that people assess the means at their disposal against their ends. At any time, they may have an abundance of ends that they would like to achieve but are limited by the scarcity of means. Once more means become available, a greater number of ends, or goals, can be accommodated, increasing people’s living standards.

Reaching one’s goals is limited by the availability of suitable means. For example, a man in the desert requires water to quench his thirst. Possessing diamonds in this situation does him no good.

The fact that people consciously pursue purposeful actions provides us with definite knowledge, which is always valid. This knowledge sets the base for a coherent framework that permits a meaningful assessment of the economy. For instance, during an economic slump, we see a general decline in the demand for goods and services. Do we then conclude that the decline in demand has caused the recession?

We know that people strive to improve their lives, so their demand for goods and services is likely to increase, not decrease. Consequently, the decline in general demand is because people cannot support their demand. Problems on the production side, the means by which they supply goods, are the likely cause of the decline in demand. Once we have established that the likely causes of the slump are associated with supply factors, we can assess the possible reasons behind this.

According to mainstream economists, however, countering an emerging economic slump requires the central bank to increase monetary pumping. An increase in the money supply growth rate supposedly will protect the well-being of people in the economy. Money, however, does not generate wealth, as it serves as a medium of exchange. On the contrary, an increase in the supply of money will undermine the wealth-generation process and 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 popular thinking, one’s outlays on goods are not necessarily driven by real income since every person decides how much of a given real income will be used for consumption and how much for investments.

While it is true that individuals are likely to respond to changes in their incomes, the response is not automatic. Everyone assesses the change in real income against the set of goals he wants to achieve. Thus, he might decide to increase investment in financial assets rather than increase consumption.

Conclusion

Mainstream economists believe the “right” model or the “right” theory is determined by its ability to make accurate forecasts. This is a questionable way of thinking. What matters is to have a theory that explains human activity. Once that is established, it is possible to make sense of recorded human actions.