The Questionable Role of Quantitative Methods in Economics

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Commentary

Most economists are in agreement that, through statistical and mathematical methods, one can organize historical data into a useful body of information, which can serve as the basis both for economic theory and assessments of the state of the economy. It is also believed that the knowledge secured from the data is tentative since it is not possible to know all the information, and future empirical information might falsify previous theory.

Milton Friedman held that since it is not possible to establish how things really work, it does not really matter what the underlying assumptions of a theory are. According to Friedman, what matters is that the theory can yield accurate predictions. For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Based on this view, he formulates a model, which is then validated by means of statistical methods. The model is then employed in the assessments of the future direction of consumer spending. If the model fails to produce accurate forecasts, it is either replaced or modified by adding some other explanatory variables. What matters here is how well consumer outlays are correlated with various variables. In this sense, all that an economist requires is to establish a good fit between dependent variables and various other independent variables.

According to this thinking, we form a view regarding the real world based on how well various pieces of information are correlated with each other. Observe, however, that by establishing a correlation between consumer outlays and the various other pieces of information, one does not really explain the nature of consumer outlays, one just describes things. This type of analysis does not tell us much regarding the underlying cause and effect.

For example, the fact that a strong correlation was established between consumer outlays and disposable income does not imply that consumer outlays are caused by disposable income. It is quite possible that one could find a very good correlation with some other variable. Does this then imply that the other variable is the cause of consumer outlays?

To make sense of the data, we must have a prior theory, which stands on its own feet and did not emerge from the data. The empiricists and positivists pretend that they have no theory or that their theories are just derived from the data, but they fail to appreciate that their outlook is itself a presupposed theory. Instead, a sound theory must originate from reality and have an axiomatic basis that cannot be refuted. A theory that rests on the foundation that human beings act, consciously and purposefully, complies with this requirement. That human beings act cannot be refuted, for anyone who tries to do so is caught in a performative contradiction—denying human action while engaging in it.

Ludwig von Mises is the originator of this approach, which is also called praxeology. Using the knowledge that human beings act, Mises was able to deduce an entire body of economics. Consequently, Mises concluded that—contrary to the natural sciences, where the true causes are not known—the knowledge that human beings act permits economists to ascertain what the true causes are. The causes emanate from human beings themselves. Mises wrote:

“The physicist does not know what electricity ‘is.’ He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process.”

Why the Methods of the Natural Sciences Are Not Applicable in Economics

Most economists are of the view that introducing the methods of the natural sciences (e.g., physics, biology, chemistry) in economics could lead to a major breakthrough in our understanding of the world of economics. Now, while the natural scientist can isolate certain variables, he does not, however, know the laws that govern these particles. All that he can do is hypothesize regarding the “true law” that governs the behavior of the various phenomena identified. On this, Murray Rothbard wrote:

“The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.”

While in the natural sciences we cannot know the true causes definitively, this is not the case with respect to economics. The fact that man engages in purposeful action implies that causes in the world of economics are known to us—they emanate from human beings themselves and not from outside factors. In economics we do not have to hypothesize regarding the true causes—we know them. Hence, we do not require any empirical testing by means of quantitative methods to verify something which is already known to us.

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 other purposes (e.g., saving, investment). While it is true that people will respond to changes in their incomes, the response is not automatic. Every individual assesses the change in his income against the particular set of goals he wants to achieve. He might decide that, because of an increase in his income, it is more beneficial for him to increase his investment rather than to increase his consumption.

Further, a logically derived theory permits us to ascertain the reasons for the possible discrepancy between the data and the theory. Thus, according to economic theory, individuals assign a greater importance to present goods over future goods. This is necessarily true because people must see to at least some level of present consumption even to survive. Therefore, interest rates cannot be negative. If, however, we do observe negative interest rates, this does not mean that the theory is wrong but rather it forces the analyst to find out how this could have happened. Most likely, he will discover that the main reason for the discrepancy between the observed data and the theory is due to central bank monetary policies.

Again, given that causality is a necessary presupposition and, in economics, causality comes from human choices, there is no requirement to confirm cause and effect by means of quantitative methods. Furthermore, to pursue quantitative analysis implies the assignment of numbers, which can be subjected to all of the operations of arithmetic. To accomplish this, it is necessary to define an objective fixed unit. Such an objective unit, however, does not exist in the realm of human valuations. It is not possible to quantify individuals’ minds, judgments, or subjective valuations. Hence, the analysis of human conduct should be qualitative and not quantitative. If outside factors were driving human conduct, then this would imply that human beings are like robots that do not initiate their actions.

On this, Mises wrote, “There are, in the field of economics, no constant relations, and consequently no measurement is possible.”

“The mathematical method must be rejected not only on account of its barrenness,” he wrote. “It is an entirely vicious method, starting from false assumptions and leading to fallacious inferences. Its syllogism is not only sterile; it diverts the mind from the study of the real problems and distort the relations between the various phenomena.”

Conclusion

Reliance on quantitative methods as a foundation for the formation of a view about the state of the economy will generate suspect outcomes. Quantitative methods cannot produce much information about the causes. What is required to ascertain the causes is a logically deduced theory that “stands on its own feet,” i.e., a theory that is not derived from the data but that is axiomatically true. A theory originated by Mises complies with this requirement.

From Mises.org