In the natural sciences, a laboratory experiment can isolate variables, various particles and their movements. Similarly, the employment of an econometric model is an attempt to produce an economic laboratory where controlled experiments could be conducted. The idea of having such a laboratory is very appealing to economists and politicians. Once the model is built and endorsed as a good replica of the economy, politicians can evaluate the outcomes of various policies by the model.
It is argued that, via econometric models, elites can make “scientific,” research-based decisions, based on economic expertise. Such models, it is argued, enhance the efficiency of government policies and lead to a better and more prosperous economy. It is also suggested that the econometric model could serve as a referee in assessing the validity of various economic ideas. The other purpose of a model is to provide an indication regarding the future state of the economy.
By means of mathematical and statistical methods, a model builder establishes relationships between various economic variables. For example, personal consumer outlays are related to personal disposable income and the interest rates, while capital expenditure is explained by the past stock of capital, interest rates, and economic activity. An assemblage of such estimated relations—i.e., equations—constitutes an econometric model.
To judge the reliability of the model, it is compared to actual data and its predictive power. (In a static simulation, the model is solved by using actual lagged variables. In a dynamic simulation, calculated by the model-lagged variables are employed). The final test of the model is its response to a policy variable change, such as an increase in taxes or an increase in government outlays. By means of a qualitative assessment, a model builder decides whether the response is reasonable or not. Once the model is successfully constructed, it is ready to be used. According to this econometric paradigm, we form a view regarding the real world based on how well the various pieces of information correlate 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. By noting this correlation in historical data, one says nothing about the nature of things. This type of information does not tell us much regarding the underlying causes and effects. 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 presuppose a theory, which stands on its own feet and did not emerge from the data. The heart of such a theory is that it must originate from an irrefutable, consistent, non-arbitrary axiom that explains causal connections in experiential reality. An economic theory that rests on the foundation that human beings act, consciously and purposefully, complies with this requirement. This axiom cannot be refuted without performative contradiction, i.e., one who denies conscious, purposeful human action uses conscious, purposeful human action.
Ludwig von Mises—the originator of this approach—labeled it praxeology. Using the knowledge that human beings are acting consciously and purposefully, Mises was able to derive the entire body of economics. Consequently, Mises had concluded that, contrary to the natural sciences, where the true causes are not known to us, in economics, the knowledge that human beings are acting consciously and purposely permits us to ascertain what the true causes are. The causes emanate from human beings themselves.
Is the mathematical method valid in economics?
By applying mathematics, mainstream economics is attempting to follow in the footsteps of natural sciences. In the natural sciences, the employment of mathematics enables scientists to formulate the essential nature of objects. By means of a mathematical formula, the response of objects to particular stimuli in a given condition is captured. Consequently, within these given conditions, the same response will be obtained time and again.
The same approach, however, is not valid in economics. Economics is supposed to deal with acting, choosing human beings, not objects. According to Mises,
The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action.
The main characteristic or nature of human beings is that they are rational beings. They use their minds to value and choose means to accomplish ends. The usage of the mind, however, is not set to follow some kind of automatic procedure, but rather every individual employs his mind in accordance with his own circumstances. This makes it impossible to capture human nature by means of mathematical formulae, as is done in the natural sciences.
To pursue quantitative analysis implies the possibility of 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. On this Mises wrote, “There are, in the field of economics, no constant relations, and consequently no measurement is possible.” There are no constant standards for measuring the minds, the values, and the ideas of men. Humans are acting, choosing agents in unique, non-repeatable historical circumstances. Individuals have the freedom of choice to change their minds and pursue actions that are contrary to what was observed in the past, unlike heavenly bodies observed in physics. Because of the unique nature of human beings, analyses in economics can only be qualitative.
The use of mathematics in economics poses another serious problem. The employment of mathematical functions implies that human actions are set in motion by various factors. For instance, contrary to the mathematical way of thinking, individuals outlays on goods are not “caused” by income as such. In his own context, every individual decides how much of a given income will be used for consumption and how much for savings. While it is true that individuals respond to changes in their incomes, the response is not automatic, and it cannot be captured by a mathematical formula. An increase in an individual’s income does not automatically imply that his consumption expenditure is going to follow. Every individual assesses the increase in income against the goals he wants to achieve. Thus, he might decide that it is more beneficial for him to increase his savings rather than increase his consumption.
Given that human beings are governed by the freedom of choice and their unique circumstances, various policy analyses by means of models, known as “what if” or the multiplier analysis, are likely to generate questionable results. After all, to assume that a change in a government policy would leave the structure of equations intact would mean that individuals in the economy ceased to be alive and were, in fact, frozen.
Another major problem with most large-scale econometric models is that they are designed along the lines of Keynesian economic thinking. The main variable in these models is the gross domestic product (GDP), which is explained within the model framework by the interactions between various lumped data known as aggregates. The interaction between various aggregates in the model framework gives the impression that the economy is about gross domestic product, or about balance of payments, but not about human beings and human life. Obviously, this runs contrary to the fact that everything in the human world is caused by man’s purposeful conduct.
Various relatively modern additions to model-building tools, such as the introduction of the so-called ARMA methods, suffer from the same methodological problems. Mises wrote,
The mathematical method must be rejected not only on account of its barrenness. It is an entirely vicious method, starting from false assumptions and leading to fallacious inferences. Its syllogisms are not only sterile; they divert the mind from the study of the real problems and distort the relations between the various phenomena.
Conclusion
Reliance on econometric model building as a foundation for the formation of a view about the state of the economy generates suspect outcomes, at best. It is the entirely wrong paradigm for the study of economics, which is based on human action, choice, and subjective valuation. Econometrics cannot produce much information about the causes. What is required to ascertain the causes is a logically consistent and developed theory that is not derived from the data. The theory originated by Ludwig von Mises complies with this requirement.