All that the various statistical methods can do is compare the movements of various historical pieces of information. These methods cannot identify the driving forces of economic activity. Contrary to popular thinking, economics is not about gross domestic product (GDP), the consumer price index (CPI), or other economic indicators as such, but about human beings who interact with each other. It is about activities that seek to promote people’s lives and well-being.
In order to establish the state of the economy, economists employ various theories. Yet what are the criteria for how they decide whether the theory employed is helpful in ascertaining the facts of reality?
According to the popular way of thinking, our knowledge of the world of economics is elusive — it is not possible to ascertain how the world of economics really works. Hence, it is held that the criterion for the selection of a theory should be its predictive power.
So long as the theory “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the theory breaks down, the search for a new theory begins.
For instance, an economist forms the view that consumer outlays on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in assessments of the future direction of consumer spending. If the theory fails to produce accurate forecasts, it is either replaced or modified by adding some other explanatory variables.
Again, in this way of thinking, the tentative nature of theories implies that our knowledge of the world of economics is elusive. Since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. In fact, anything goes as long as the theory can yield good predictions. According to Milton Friedman,
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 approximation 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.1
The popular view that sets predictive capability as the criterion for accepting a theory is questionable.
We can say confidently that, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot predict the future price of bread? According to Mises,
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative.”2
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