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Economic Analysis and the Limits of Empirical Data and Model Driven Conclusions
Mises: "Economics is not only not derived from experience, it is even impossible to verify its theorems by appeal to experience."
CJay Engel comment 0 Comments access_time 11 min read

We live in the age of the anti-apriori; a complete rejection of any theory which exists independent of “the data.” This refusal to embrace or even consider the importance of theory advertises itself as a commitment to “evidence,” “hard-facts,” and independence from ideologies and biased interpretations. Any attempt to challenge the usefulness of “facts” independent of theory or interpretation is disregarded as extremist, ideological, and therefore rank kookery— worthy of dismissal without engagement.

By approaching the social sciences as a series of brute facts that need no interpretation, there is rarely, if ever, even a remote thought given to cause-and-effect, definitions and assumptions, and the presence of volitional human action. Instead, we are merely treated to a blaring “you can’t argue with the facts” response to any attempt at rational inquiry.

For instance, in the recent and now viral exchange between Jordan Peterson and Cathy Newman, Newman kept driving home her own “brute fact” as if it were self-interpreting. The “fact,” of course, was that “the gender wage-gap exists.” Peterson indicated that it was important to interpret it, to explain why it “existed” (generously assuming, for the sake of the argument, that it actually did exist). By looking at why it existed we might be able to determine whether it had nefarious causes.

But Newman was intent on repeating without rational inquiry: “but it exists! It’s a fact!” As if that very declaration was proof of its being some great social evil.

Among the areas most affected by this mindset is the realm of economic science. In the place of theory, economic commentators have become obsessed with data-point driven narratives that rely heavily on mathematics, statistics, formulas, and other models. In doing so, they have separated economics from its true foundational presupposition: individual human action in a world of scarce resources and varying life circumstances.

A relevant example of this can be found in the rising social narrative of income inequality, which recently has been “academicized” by the work of French Neo-Marxist Thomas Piketty. The key formula that underlies his entire work is represented as: α = r X β. All that is being communicated here is that the share of all income which goes to capital (α) is equal to the rate of return on the capital ( r ) times the capital to income ratio (β). If that is overwhelming, stay with me, you don’t need to fully grasp that to understand my point.

As Randall Holcombe states in his review of Piketty’s book, this is simply an “accounting identity.” That is, it makes sense, mathematically, that the capitalist’s (the owner of the capital) income is equal to the rate of return times the dollar value of the capital asset. If he owns $100 of capital, and the rate is, say, 4%, his income is $4. However, Holcombe keenly observes:

“Piketty’s equation, α = r X β, aggregates all the individual decisions so that—while it is accurate in an accounting sense—it is misleading in an economic sense.”

That is to say, without theory, we merely have a formula, the interpretation of which must be imputed to it. Piketty, having no underlying economic theory, uses the formula in such a way as to make it appear as if the capitalist receives income simply because he owns capital. But economically, that is, with theory to guide us, we have the ability to recognize the cause and effect that undermines Piketty’s use of the formula in his narrative.

Because Piketty does not consider the underlying relationship (which can only be analyzed by reflecting on the implications of human action) between capital and the income produced from capital, he has no theory to prevent him from reaching the mistaken conclusion that receiving a return on capital is a passive activity; that it requires no economic contribution on the part of the capitalist.

That is, the value of the capital (β) does not just “exist” and therefore produces for its owner an income. Rather, the value of the capital depends on the cash flow that can be earned by putting the capital to productive use! Hence, Holcombe argues:

Piketty uses the relationship α = r X β, but a more accurate way to depict the economic relationship is β = α / r. The expressions are mathematically equivalent, but Piketty’s way of showing it assumes that the value of capital determines its return, rather than the more economically accurate depiction in which the return produced by the capital determines its value.

To clarify Holcombe’s point: formula without theory is so flexible so as to be completely useless if we seek to understand economic relationships. Capital must be employed in such a manner so as to produce positive returns. Thus, capital only earns a return if its application benefits the situation of others, as expressed in their voluntary actions. If it is not employed in such a manner, the capital produces losses, a negative income.

All this to say that “data” can only describe past phenomena— it can never explain it. As philosopher Gordon Clark once noted: “A statement of fact is not an explanation: it is the very thing that needs to be explained.” Economic laws cannot be arrived at by the collection of data; this is because empirical data accumulation itself does not take into account human volition and action. And the attempt at economic science emptied of the essence of mankind itself is dead on arrival.

Thus, by ignoring human action, the modern “economist” rejects the true foundation of economic science. Instead the modern study of these problems have adopted methods borrowed from the physical sciences. Among these, Murray Rothbard describes:

Model-Building: Economics, and recently political science, have been beset by a plague of “model-building.” People do not construct theories any more; they “build” models of the society or economy. Yet no one seems to notice the peculiar inaptness of the concept. An engineering model is an exact replica, in miniature, that is, in exact quantitative proportion, of the relationships existing in the given structure in the real world; but the “models” of economic and political theory are simply a few equations and concepts which, at very best, could only approximate a few of the numerous relations in the economy or society.

Measurement: The Econometric Society’s original motto was “Science is measurement,” this ideal having been transferred intact from the natural sciences. The frantic and vain attempts to measure intensive psychic magnitudes in psychology and in economics would disappear if it were realized that the very concept of measurement implies the necessity for an objective extensive unit to serve as a measure. But the magnitudes in consciousness are necessarily intensive and therefore not capable of measurement.

The Mathematical Method: Not only measurement but the use of mathematics in general in the social sciences and philosophy today, is an illegitimate transfer from physics. In the first place, a mathematical equation implies the existence of quantities that can be equated, which in turn implies a unit of measurement for these quantities. Second, mathematical relations are functional; that is, variables are interdependent, and identifying the causal variable depends on which is held as given and which is changed. This methodology is appropriate in physics, where entities do not themselves provide the causes for their actions, but instead are determined by discoverable quantitative laws of their nature and the nature of the interacting entities. But in human action, the free-will choice of the human consciousness is the cause, and this cause generates certain effects. The mathematical concept of an interdetermining “function” is therefore inappropriate.

Indeed, the very concept of “variable” used so frequently in econometrics is illegitimate, for physics is able to arrive at laws only by discovering constants. The concept of “variable,” only makes sense if there are some things that are not variable, but constant. Yet in human action, free will precludes any quantitative constants (including constant units of measurement). All attempts to discover such constants (such as the strict quantity theory of money or the Keynesian “consumption function”) were inherently doomed to failure.

Finally such staples of mathematical economics as calculus are completely inappropriate for human action because they assume infinitely small continuity; while such concepts may legitimately describe the completely determined path of a physical particle, they are seriously misleading in describing the willed action of a human being. Such willed action can occur only in discrete, non-infinitely-small steps, steps large enough to be perceivable by a human consciousness. Hence the continuity assumptions of calculus are inappropriate for the study of man.

Of all economists in history, Mises perhaps was most keenly aware of the importance of theory, independent of the “data:”

You cannot, for instance, discuss the Soviet system without falling back on the general principles both of capitalism and socialism. You cannot discuss a wage and hours bill without falling back on the theory of wages, profits, interests and prices, that means the general theory of a market society. The “pure fact”—let us set aside the epistemological question whether there is such a thing—is open to different interpretations. These interpretations require elucidation by theoretical insight.

Economics is not only not derived from experience, it is even impossible to verify its theorems by appeal to experience. Every experience of a complex phenomenon, we must repeat, can be and is explained in different ways. The same facts, the same statistical figures are claimed as confirmations of contradictory theories.

Thus:

The relation between historical experience—for every economic experience is historical in the sense that it is the experience of something past—and economic theory is therefore different from that generally assumed. Economic theory is not derived from experience. It is on the contrary the indispensable tool for the grasp of economic history. Economic history can neither prove nor disprove the teachings of economic theory. It is on the contrary economic theory which makes it possible for us to conceive the economic facts of the past.

Any set of data or other observations can be interpreted, if one is interested in doing so, with the tool of theory. But such interpretation only provides us with historical information– information about the specific arrangement and conglomeration of a nearly infinite number of variables. At a certain time and place, in a certain political context, given a certain structure of prices and arrangement of factors of products, given certain consumer preferences, given the place in the business cycle, given the rate of interest, given so many other factors, a certain– and very blurry– conclusion can be reached about the specific situation. Perhaps the conclusion is interesting, but it is mere history, having nothing to do with economic theory. There is a distinction between theory and history therefore, with the former being the implications of human action, the latter being mere and vague observations of past events.

As proponents of the free market, we don’t need the experiences of Venezuela to “teach us” that socialism doesn’t work. We don’t need to cite the murderous regimes of Stalin, Hitler, and Mao as proof of the inevitable collapse of collectivist and state-totalitarian social arrangements. Socialism doesn’t work in theory. Interventionism as democratic policy contradicts what is known about the very nature of man. Economic theory itself warns the careful thinker of the regressive civilizational effects of both a tinkering with the free market and full-on government control. The data, the formulas, the empirical studies, produced by the econometricians need to be challenged on their foundation: the baseless assumption that these things in themselves can have anything to offer economic theory and government policy.