Economics and the Real World
Various assumptions employed by mainstream economists are detached from reality. For instance, in order to explain the economic crisis in Japan in the 1990s, Nobel laureate in economics Paul Krugman employed a model that assumes that people are identical and live forever and that output is given. While admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model could be useful in offering solutions to Japan’s economic crisis.
According to David Gordon, Eugen von Böhm-Bawerk held that concepts employed in economics must originate from the facts of reality—concepts need to be traced to their ultimate source. If a concept cannot be shown to be grounded in reality, it should be rejected as meaningless.
Similarly, Ayn Rand held that concept formation is not arbitrary. The role of concepts is to integrate relevant existents, while the role of definitions is to identify the nature a concept’s existents. According to Rand in her Introduction to Objectivist Epistemology,
A definition is a statement that identifies the nature of the units subsumed under a concept. It is often said that definitions state the meaning of words. This is true, but it is not exact. A word is merely a visual-auditory symbol used to represent a concept; a word has no meaning other than that of the concept it symbolizes, and the meaning of a concept consists of its units. It is not words, but concepts that man defines—by specifying their referents. The purpose of a definition is to distinguish a concept from all other concepts and thus to keep its units differentiated from all other existents.
The employment of assumptions that are detached from the facts of reality originates in the writings of Milton Friedman, the head of the monetarist school of thinking. According to Friedman in his Essays in Positive Economics, since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a model are:
The ultimate goal of a positive science is the development of a “theory” or “hypothesis” that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed. . . . The relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
Observe that on this way of thinking, anything goes as long as the model can generate accurate forecasts.
The forming of concepts and definitions arbitrarily is not something that should be taken lightly. A case in point is the mandate of the central bank to pursue policies aimed at stabilizing the price level—the total purchasing power of money. However, the concept of the price level cannot be traced to anything in the real world. It is not possible to add up the purchasing power of money with respect to various goods and services in order to obtain its total purchasing power.
Let us say, for example, that the purchasing power of a unit of money was established in the market as two potatoes and one loaf of bread. One cannot add up two potatoes and one loaf of bread in order to establish the total purchasing power of a unit of money with respect to bread and potatoes. If one cannot ascertain what something is, then obviously it is not possible to keep it stable. A policy aimed at stabilizing a fiction can only lead to disaster.
Likewise, if one defines inflation as increases in the prices of goods and services while ignoring the valid definition of inflation (increases in the money supply), one is likely to set in motion policies that will undermine the well-being of individuals rather than protecting them from the menace of inflation.
On this Ludwig von Mises wrote,
To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying “catch the thief.” The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.
Observe that an increase in prices need not always follow an increase in the money supply (i.e., inflation). It can happen that the effect on prices of an increase in money supply is curtailed as a result of increases in the production of goods. Hence, prices could remain stable while inflation is strengthening. In the meantime, this strengthening in inflation (i.e., increase in the money supply) undermines wealth generation and sets in motion the menace of the boom-bust cycle.
Note that the damage to the wealth generation process will take place regardless of increases in the production of goods and services. According to Murray Rothbard, “The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.” Because of their false definition of inflation, most economists focused on the increases in the prices of goods and services while ignoring increases in the money supply. Those increases in the money supply set in motion the severe economic slump known as the Great Depression.
According to mainstream economics, which follows the views of Milton Friedman, because the facts of reality cannot be known, the validity of a theory is assessed based on how accurately it can predict the future. However, a theory based on false concepts cannot be declared valid because it made accurate predictions during a particular time interval. If a theory is based on false concepts, its forecast cannot be trustworthy.