On Theory and Measurement in Economic Analysis

Introduction

The discussion about theory and measurement is not new in economics debates. Three Nobel laureates, Theodore Schultz, Milton Friedman, and Tjalling Koopmans wrote extensively on this subject. Tjalling Koopmans, in his 1947 article entitled Measurement Without Theory, noted that theory consists of models of individual optimizing agents/or equilibrium in market-like interactions between optimizing agents, preferably in mathematical forms. Whether we agree with him or not on this very precise point is not the purpose of this essay. The purpose of this essay though is to argue why relying on economic theory alone is an insufficient approach to determine the real value of economic analysis.

I - The Essence of Economic Theory

A theory is a supposition or a system of ideas intended to explain something, especially one based on general principles independent of the thing being explained. This definition of a theory suggests that it offers an alternative explanation to something factual. In economic analysis, the theory plays an important role in defining the foundations of the framework on which the analysis is based. Economic theory is hypothetical in nature because it is founded on a set of assumptions and these assumptions which constitute a theoretical framework, aim to explain what reality could be; and not what reality is.

Economic theory is founded on a priori reasoning. The reason why a theory can only be developed through a priori reasoning is that its role is to enhance our understanding of the phenomenon being explained. And this can only be done through the use of logical reasoning, whether qualitatively or quantitatively.

But it is quintessential to fathom that the phenomenon being explained proves in no way, shape, or form that theory used to explain it is actually real. If the theory is real, it is no longer a theory, it is a fact, and facts are not a priori, they are a posteriori because they are based on observations.

Theory is not reality because it is based on a set of assumptions, and these assumptions are used by the theorist to explain, according to his understanding, what reality could be. This necessarily implies an implicit bias of the theorist using his arguments to explain what happened.

Theories are disputed, not the facts. Economists have always disagreed on the causes of the Great Depression. The Great Depression has happened. This is a fact. We can observe that it did occur. Now the question is why it has occurred? This is when economists attempt to explain the facts according to their subjective understanding and biases of the occurrence. Three major economic theories have been developed to explain why the Great Depression occurred: (1) the Austrian theory of the business cycle developed by Austrian economists Ludwig von Mises and Friedrich von Hayek, (2) the Chicago quantity theory of money developed by the Chicago economist Milton Friedman, and (3) the Keynesian theory of unemployment, interest, and money developed by Cambridge economist, John Maynard Keynes.

In a nutshell, (1) the Austrian theory argued that the government and the central bank were responsible for triggering the Great Depression because they interfered in the market process by lowering interest rates, which led to an expansion of credit, and this expansion of credit led to malinvestment from entrepreneurs and this malinvestment led to an economic expansion that was deemed unsustainable, and this unsustainable expansion eventually led to the crash of the market. (2) The quantity theory of money argued that the crash occurred because the Federal Reserve failed to increase the money supply to its nominal level. In failing to prevent the drop in the money supply, the economy went into a contraction where output sharply declined over a sustainable period of time. (3) The Keynesian theory argued that what caused the Great Depression was a fall in aggregate demand. According to Keynes, this fall in aggregate demand was generated by a loss of confidence in the market that led to drastically lower investment and persistent underconsumption.

We see that we have three different stories related to one fact. Now, the great question here is to know how do we determine who is the most correct of all if none of these theories are tested empirically? If theory was reality, then we would not have three different stories gravitating around one single fact. All economists would have agreed and no debate would be needed. Each of these theories developed to explain the Great Depression was done so based on their subjective political bias. Each of these theories was developed from a priori reasoning through logical reasoning with a set of various assumptions. It is important to know that no theory is correct by essence because of its hypothetical nature. It is impossible to know if a hypothesis is correct or not until it is confronted with data and real-life experience.

Regardless of where we stand when it comes to the economic school of thought, none of the theories we believe in are entirely; 100%; and thoroughly correct and accurate. Each theory has some defect. This is why, in order to determine the strengths and weaknesses of a theory and how applicable it can be, it is necessary to test it empirically.

II - Measurement of Economic Theory

It is remotely impossible to determine the practical consequences of a theory unless it is empirically tested. It is impossible just from a priori reasoning to know how practically impactful a theory could be. To answer the question posed about the Great Depression, each of these theories has been tested empirically and each of them does have some degree of validity. None of them is entirely valid. The most accepted version of these three theories by professional economists is the one argued by Milton Friedman based on how the results were consistent with the data.

If Friedman’s theory has not been empirically tested, it would have not been accepted as the official version of the cause of the Great Depression. Ben Bernanke, the former Chairman of the Federal Reserve, in 2002 publicly admitted that the Fed’s mismanagement of the money supply was the principal reason why the crisis occurred. This example alone demonstrates why it is crucial to test economic theories.

Economists such as Paul Samuelson, Ludwig von Mises, or Gérard Débreu, were considered pure theoretical economists. Samuelson and Debreu used mathematical methods to develop their theories while Mises used verbal reasoning to develop his. Each of these men has done important work in the field of economic theory that cannot be denied. Samuelson developed many economic theories such as reveal preferences, or capital theory, Debreu proved mathematically that there is an equilibrium that exists in a competitive economy by using topological methods, and Mises developed the theory of economic calculation in socialist economies which argues that socialist economies are doomed to fail because they have no pricing system to determine what consumers really want.

Each of these men dedicated their professional careers to the advancement of economic theory and abstract reasoning. Yet, each of these men never bother to test the validity of their theories but truly believed in them as if they were gospel. If we take Debreu for example, he mathematically proved the existence of an equilibrium in a market economy but this proof is only mathematical proof. It is only concerned with pure abstract reasoning. How his mathematical proof of the existence of an equilibrium corroborates with reality? How can we understand and assess its practical implications? Samuelson developed his theory of revealed preference where he used rigorous mathematical techniques such as linear programming and partial derivatives to elucidate consumer behavior. Again, how does Samuelson’s revealed preference theory corroborate with reality? What are its practical ramifications? When people go grocery shopping for example, do they exactly behave like his model predicted? Mises’s economic calculation problem was not developed mathematically but through verbal reasoning. He predicted that the socialist system of the Soviet Union would fail because the lack of a price system prevent the rational allocation of resources. But Mises did not present any concrete historical evidence to corroborate that theory. His theory was grounded on pure logical reasoning. Nonetheless, the Soviet Union failed, and the members of the Austrian School of Economics attribute the USSR’s failure strictly to Mises’s theory of the economic calculation problem. The evidence however points out that the Soviet Union’s failure was due to several political, military, and social factors. Not just economic. Maintaining these satellite states became costly for the Soviet Union as some of these states began to revolt and request their independence, and maintaining the nuclear arms race with the United States also drained the Soviet economy. Mises died in 1973. Before his death, the Soviet Union was economically strong, and there was already some data to assess its economic and military output. Mises could have supplied some data in comparing the output of nuclear weapons for the United States and for the Soviet Union to show how investing intensively in nuclear weapons would eventually have collapsed the Soviet economy. I believe this little piece of evidence if added to the ECP theory, would have made the economic calculation problem even stronger than it already is. It would have helped us assess the practicality of the economic calculation problem.

Let me reiterate once again that economic theory is crucial in the development of economic analysis. However, relying solely on economic theory to answer economic questions is fallacious because economic questions are of practical importance. Economic theory only enhances our understanding of economic phenomena by offering alternative explanations but does not offer any practical answer. Practical questions can only be answered when economic theory is measured. Economic theory could be measured by statistical methods or historical methods, everything depends on the nature of the theory and its framework (whether the theory was built qualitatively or quantitatively). However, based on conventional wisdom, economic theory is measured through statistical methods rather than historical methods because economic theories are constructed based on mathematical models.

Testing economic theories help us determine which part of the theory is compatible with reality and which part isn’t. Testing our theories helps to correct our assumptions if they are wrong. Untested mathematical models do not reflect reality at all. They may look like a beautiful piece of intellectual art to admire, but their utility shows no value until their practical implications are determined. Praxeological statements also do not reflect reality. Mathematical models and praxeological statements are both based on assumptions, therefore, on a priori reasoning. Once they have been logically developed and argued, they ought to be tested.

III - Conclusion

Economics is the science of decision-making and the science of the allocation of scarce resources for alternative uses. People believe in economics because it is the field that helps them answer questions about the improvement of their material welfare. To help people improve their material well-being, it is important to test the theories we are telling them. In testing our theories, we are showing them what could work and what could not work. Testing our theories forces us, economists, to be responsible for our ideas and their consequences because ideas have consequences and a theory is never independent of its practical implications. This essay exhorts theoretical economists to get their hands dirty with empirical data and to not stop their analysis strictly at the theoretical level.