We often hear from central bank officials that their decisions regarding the interest rate policy is determined by the state of economic conditions as depicted by economic indicators. Policymakers are of the view that, in order to ascertain the state of economic conditions, they require the most recent information on some key economic data such as the gross domestic product (GDP). Thus, an increase in the GDP growth rate is seen as economic growth. A weakening in the growth rate of GDP raises the likelihood of the officials lowering the policy interest rate.
Various economic indicators, including the GDP data, are a display of historical data. History, by itself, cannot inform us about the state of an economy. It cannot tell us whether the fundamentals of the economy are improving or deteriorating. According to Ludwig von Mises, in Human Action,
History cannot teach us any general rule, principle, or law. There is no means to abstract from a historical experience a posteriori any theories or theorems concerning human conduct and policies.
Hence, to make sense of data, a theory is necessary beforehand that will guide an analyst in the interpretation of the data. In fact, this is inescapable, even for so-called empiricists and positivists. In his Philosophical Origins of Austrian Economics, David Gordon writes that Böhm-Bawerk maintained that concepts employed in economics must originate from the facts of reality—they need to be traced to their ultimate source. If one cannot trace it, the concept should be rejected as meaningless. A theory that rests upon the idea that human beings are acting, consciously and purposefully, fulfils this criterion.
That human beings act cannot be refuted, for denial of human actions requires action. Any denial requires an affirmation. Ludwig von Mises labeled this approach as praxeology. This basis allows one to make sense of historical data. According to Rothbard,
One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was in looking at Grand Central Station behavior during rush hour. The “objective” or “truly scientific” behaviorist, he pointed out, would observe the empirical events: e.g., people rushing back and forth, aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see the purpose is to get from home to the train to work in the morning, the opposite at night, etc. It is obvious which one would discover and know more about human behavior, and therefore which one would be the genuine “scientist.”
Hence, an analyst that is looking at the data without a theory cannot provide the reason for data changes. All that he can do is just to describe the changes. Again, without a theory, it is not possible for him to explain the reason for changes in the data.
Why Methods of Natural Sciences Do Not Apply in Economics
Most economists are of the view that the introduction of the methodology of natural sciences in economics could lead to a major breakthrough in our understanding of the world of economics.
According to Rothbard,
This methodology, briefly, is to look at facts, then frame ever more general hypotheses to account for the facts, and then to test these hypotheses by experimentally verifying other deductions made from them. But this method is appropriate only in the physical sciences, where we begin by knowing external sense data and then proceed to our task of trying to find, as closely as we can, the causal laws of behavior of the entities we perceive. We have no way of knowing these laws directly; but fortunately, we may verify them by performing controlled laboratory experiments to test propositions deduced from them. In these experiments we can vary one factor, while keeping all other relevant factors constant. Yet the process of accumulating knowledge in physics is always rather tenuous; and, as has happened, as we become more and more abstract, there is greater possibility that some other explanation will be devised which fits more of the observed facts and which may then replace the older theory.
In contrast,
In the study of human action, on the other hand, the proper procedure is the reverse. Here we begin with the primary axioms; we know that men are the causal agents, that the ideas they adopt by free will govern their actions. We therefore begin by fully knowing the abstract axioms, and we may then build upon them by logical deduction… Furthermore, in human affairs, the existence of free will prevents us from conducting any controlled experiments; for people’s ideas and valuations are continually subject to change, and therefore nothing can be held constant. The proper theoretical methodology in human affairs, then, is the axiomatic-deductive method. The laws deduced by this method are more, not less, firmly grounded than the laws of physics; for since the ultimate causes are known directly as true, their consequents are also true.
Whilst a scientist can isolate various entities, he does not, however, know the laws that govern these entities. All that he can do is hypothesize regarding the “true law” that governs the behavior of the various entities identified. He can never be certain regarding the “true” laws of nature. Empirical natural sciences aim at probability based on observation of facts, but new data can cause a reworking of the theory. However, in economics, we know the causes because human beings are acting consciously and purposefully. This knowledge, in turn, helps us to understand the world of economics. Hence, in economics we don’t assume or guess, we know.
The fact that individuals act implies that causes in the world of economics emanate from human beings. For instance, contrary to popular thinking, individual’s 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 he is going to use for consumption. Every individual assesses the changes in income against the particular set of goals he wants to achieve.
Now, according to economic theory, individuals assign a greater importance to the consumption of goods at present versus the consumption in the future. This preference towards the present consumption versus the future consumption comes from the fact that one must consume at present, at some level. Hence, present consumption is at a premium to future consumption. The premium is what interest is all about. Mises held,
He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future.
Therefore, the interest rate cannot be negative. If, however, we do observe negative interest rates, this raises the likelihood that a possible reason for this is the central bank’s monetary policies that distort the market interest rates.
Conclusion
Reliance on historical data as a basis for the formation of a view about the state of the economy is problematic. Those claiming to build a theory from observation and historical information miss the fact that they already pre-possess an unacknowledged theory for the interpretation of data. Central bank officials (or anyone else) that rely solely on the historical data in their interest rate policy run the risk of undermining individuals’ well-being.
