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The War Over Method

July 17, 2002

'Choque con la Lujuria' by Lorenzo DominguezIn the midst of the debate between Keynesian and monetarist economists, the positions of these two groups came to be known as "saltwater economics" and "freshwater economics," respectively. These labels derived from the location of centers of Keynesian thought (MIT and Harvard) near an ocean and the location of the center of monetarist thought (the University of Chicago) near the Great Lakes.

In his desire to differentiate the Austrian position from others, the late Murray Rothbard labeled his school of thought "no-water economics"--reflecting his surroundings at the University of Nevada. The hydrological surroundings of the economists in question are purely a matter of geographic accidents. However, there are methodological differences between these schools that make these labels, with slight modification, quite appropriate.

Austrian economists accept that economic theory is logically prior to data. Economic theory is a set of logical propositions that derive from the fundamental axiom that man acts purposefully. Each individual knows his own circumstances, imagines a better state of affairs, can perceive means by which he can bring about the more desired state of affairs, and then acts to accomplish this goal. This is the fundamental principle from which economic theory derives. Historical data are important to social theory, but they are incomprehensible without the theoretical concepts that we need to interpret them.

Since Austrians ground their arguments on a priori truths, we might call it "dry-land economics." Due to their methods, Austrian economists have their feet planted firmly on solid ground. The array of data that historians face is vast, and statistical techniques are far from perfect. This causes us no concern, however, because we always stay in direct contact with sound theoretical propositions that enable us to make sense out of the sea of data we face beyond the limits of the theoretical grounding of our science.

Chicago economists deny this approach. Following the methodological prescriptions of Milton Friedman, Chicago economists contend that we can test theory with data and that theory which fails such tests is false. Chicago economists disdain the dry land that Austrians find so important. Instead, Chicago economists engage in perpetual fishing expeditions as they grope for data in the murky depths of history.

Chicago efforts are not without merit. History has its uses. In an interview, Chicago economist Ronald Coase claims that history demonstrates the failure of recent governmental regulations.

I don't reject any policy without considering what its results are. If someone says there's going to be regulation, I don't say that regulation will be bad. . . . What we discover is that most regulation does produce, or has produced in recent times, a worse result. But I wouldn't like to say that all regulation would have this effect because one can think of circumstances in which it doesn't. . . . Almost all the studies--perhaps all the studies--suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up. ("Ronald Coase Talks to Thomas Hazlett," by Thomas Hazlett, Reason magazine, January 1997)

Thus, Coase contends that empirical observation drives analysis, and that this analysis shows we are far too regulated. In particular, Coase himself has shown historically that private industry can supply lighthouses and deal with property rights problems in the electromagnetic spectrum[1].

The historical and statistical research that Chicago economists conduct serves as an anchor that keeps them in contact with the earth below. Honest efforts to sort out the historical record generally illustrate the effectiveness of markets. Data are not always clear, however. The trouble with anchors is that anchor lines allow for drift. Given the prevailing ideological winds, statistical slack in our metaphorical anchor line can allow otherwise good economists to drift away from the positions that theory tells us are true.

Unfortunately, it is often the case with Chicago economists that we observe them drifting in the wrong direction. Chicago Nobelist George Stigler once wrote that the sugar subsidy is efficient because it has stood the test of time.[2] Thus, we are supposed to infer economic efficiency directly from historical observation, no matter how little sense it makes. Their insistence in using real statistics to anchor their position prevents them from drifting as far off as others. In contrast, Austrians--with their feet firmly planted on the ground--can stand firm against even the strongest ideological storms.

The label "freshwater economics" holds for Chicago, since the depths of most lakes permit the use of anchors. Similarly, the inability to use an anchor in most oceangoing ventures fits the "saltwater" label of Keynesian economists.

Keynesians deny even the most fundamental propositions of economic theory. In his debate with Hayek during the 1930s, Keynes refused to accept the time-preference theory that Hayek advocated. Following Mises and Böhm-Bawerk, Hayek contended that interest rates coordinate individual decisions to save and spend. Government reductions in interest rates through inflation then drive the boom-bust cycle.

Keynes insisted that individuals act according to marginal propensities to save and spend. This peculiar view of human behavior is a denial of the purposeful and rational nature of human conduct in markets. This false proposition leads to the equally false conclusion that the level of spending, rather than the level of interest rates, drives cycles. According to this "theory," the drastic reduction in government spending at the close of the Second World War should have caused a massive depression in 1946. As Lowell Vedder and Richard Gallaway have shown,[3] Keynesians did predict this and, obviously, were wrong by a wide margin.

Did this empirical failure damage the Keynesian movement? Not at first. Most Keynesians at the time shrugged off this episode and continued to advocate their theory. Milton Friedman and Anna Schwartz did eventually succeed in using statistics to get most Keynesians to moderate their positions. However, Friedman and Schwartz by in large accepted the faulty Keynesian framework. Consequently, they never appreciated the full extent of Keynesian folly.

Such economists still exist today. A Princeton study by David Card and Alan Krueger purported to show that raising minimum wages increases employment among low-skilled workers. Their original study derived from a survey of fast-food restaurants in central New Jersey and eastern Pennsylvania. Given that this study contradicts theory, many questioned it, and it has not held up well to scrutiny.

Thus, we can see that some economists hang an anchor line with no anchor in the water to give the appearance that their work has some connection to reality, while the political winds blow them where they will. This study did succeed, however, in securing a position for one of its authors in the Clinton administration. Recent Nobel Prizewinner Joseph Stiglitz also joined the Clinton administration to take up the fight against the law of demand in labor markets.

The historical method in social science also served the purposes of the two great totalitarian movements of the twentieth century. German historicists such as Werner Sombart joined the Nazi movement as Fascism set Germany on a course with disaster. Marxian historicists also sent Russia and many other nations off to have their economies wrecked in a storm of socialist intervention.

Mises and Hayek gave warning to those socialists who, in looking for answers where they were not to be found, would cause catastrophic suffering for millions. It is precisely because they understood and believed in sound economic theory that they knew history would teach tragic lesson to those who followed the advice of those who relied on history, rather than on theory, to choose between capitalism and socialism.

These episodes illustrate the vital importance of theory in conducting sound economic analysis. The winds of politics and ideology are often strong. We need sound theoretical concepts to take a firm stance against such forces. Data alone will not keep us grounded, and indulging in socialist fantasies end only in our sinking to the worst depths of poverty and despotism.

D. W. MacKenzie is a Ph.D. candidate and a Walter Williams fellow at George Mason University. Send him EMAIL.

[1] See his "The Lighthouse in Economics," Journal of Law of Economics (1974), and "The Federal Communications Commission," Journal of Law and Economics (1959).

[2] George Stigler, "Law or Economics," Journal of Law and Economics (1992).

[3] See "The Great Depression of 1946" in Review of Austrian Economics (1991).

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