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Why Do Economists Make so many Arbitrary Assumptions?

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05/16/2018

Various assumptions employed by mainstream economists appear to be of an arbitrary nature. The assumptions seem to be detached from the real world.

For example, in order to explain the economic crisis in Japan, the famous mainstream economist 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 can be useful in offering solutions to the economic crisis in Japan.1

The employment of assumptions that are detached from the facts of reality originates from the writings of Milton Friedman. According to Friedman, 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. In fact anything goes, as long as the model can yield good predictions. According to Friedman,

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 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.2

Observe that on this way of thinking, the formation of the view regarding the real world is arbitrary – in fact, anything goes as long as the model could generate accurate forecasts. 

In his "Philosophical Origins of Austrian Economics," David Gordon wrote that Bohm 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.

Similarly, Ayn Rand has suggested that concept formation is not something arbitrary. The role of concepts is to integrate relevant existents while the role of definitions is to identify the nature of existents of a concept. According to Rand,

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 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.3

The purpose of a definition then is to distinguish a given group of existents from other existents. Given that a definition provides the essence of existents of a particular concept, obviously then definitions are not arbitrary. At any stage, it is determined by the facts of reality, within the context of one’s knowledge.

For instance, one can observe that people are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street or dining in restaurants. The essence of these activities is that they are purposeful.

Furthermore, we can establish the meaning of these activities. Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals like buying food or clothing. Dining in a restaurant can be a means for establishing business relationships. Driving a car may be a means for reaching a particular destination.

The knowledge that human actions are purposeful also implies that they are conscious.

Popular economics employs arbitrary definitions

The arbitrary nature of popular economics is depicted by how it defines money supply. According to mainstream economics the correct definition of money is not something permanent but flexible. What dictates whether M1, M2 or some other M will be labeled as money is its correlation with national income. On this way of thinking, sometimes M2 could be considered as the valid definition of money and on some other occasion it could be some other M.

Most economists hold that since the early 1980’s, due to financial deregulation the nature of financial markets has changed and consequently past definitions of money do no longer hold. On this Rothbard wrote,

The Chicago School defines the money supply as that entity which correlates most closely with national income. This is one of the most flagrant examples of the Chicagoite desire to avoid essentialist concepts, and to “test” theory by statistical correlation; with the result that the supply of money is not really defined at all. Furthermore, the approach overlooks the fact that statistical correlation cannot establish causal connections; this can only be done by a genuine theory that works with definable and defined concepts.4

According to Salerno,

Measures of the U.S. money stock in current use in economic and business forecasting and in applied economics and historical research are flawed precisely because they are not based on an explicit and coherent theoretical conception of the essential nature of money. Given the all-pervasive role of money in the modern market economy, existing money-supply measures therefore tend to impede, rather than to facilitate, a clear understanding of the past or future development of actual economic events.5

To establish the definition of money we have to ascertain how the money-using economy came about. Money emerged because of the fact that barter could not support the market economy. The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity. On this Mises wrote,

There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.6

Money is the thing that all other goods and services are traded for. This fundamental characteristic of money must be contrasted with other goods. For instance, food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that in turn will permit the production of a larger quantity of goods and services. Contrary to mainstream thinking then, the essence of money has nothing to do with financial deregulation, as the essence of money will remain intact in the most deregulated of markets.

Through the ongoing selection process over thousands of years, people have settled on gold as money. In other words gold served as the standard money. In today’s monetary system the core of the money supply is no longer gold, but coins and notes issued by the government and the central bank. Consequently, coins and notes constitute the standard money also known as cash that is employed in transactions.

Why arbitrary formations of concepts and definitions undermine individuals’ well-beings?

The arbitrary process of forming concepts and definitions in mainstream economics is not something that should be taken lightly. For instance, one of the main mandates of the central bank is to pursue a policy that is aiming at stabilizing the price level.

The concept of the price level however, cannot be traced to anything real for it does not exist. It is not possible to add up the purchasing power of money with respect to various goods and services in order to obtain the total purchasing power.

For instance, the purchasing power of a unit of money is established in the market as two potatoes and one loaf of bread. Arithmetically one however cannot add up two potatoes to one loaf of bread in order to establish the total purchasing power of a unit of money with respect to bread and potatoes.

If we cannot ascertain what something is, then obviously it is not possible to keep it stable. A policy that is aimed at stabilizing a fiction can only lead to a disaster.

Likewise, if one defines inflation as changes in the prices of goods and services while ignoring the valid definition of inflation being changes in the money supply, one is likely to set in motion policies that will undermine the well-beings of individuals rather than protecting them from the menace of inflation.

To gain insight into the state of an economy, economists rely on statistical indicators called Gross Domestic Product (GDP). The GDP framework looks at the value of final goods and services produced during a particular time interval, usually a quarter or a year.

The idea of GDP gives the impression that there is such a thing as the national output. In the real world, however, wealth is produced by someone and belongs to somebody. Goods and services are not produced in totality and supervised by one supreme leader. This in turn means that the entire concept of GDP is devoid of any basis in reality. It is an empty concept.

In addition to all these issues, there are serious problems regarding the calculation of GDP. To calculate a total, several things must be added together. To add things together, they must have some unit in common. It is not possible to add refrigerators to cars and shirts to obtain the total of final goods. Since the total real output cannot be meaningfully defined, obviously it cannot be quantified.

So what are we to make out of the periodical pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping.

As a rule, the more money created by the central bank and the banking sector, the larger the monetary spending will be. This in turn means that the growth rate of what is labeled as the real economy will closely mirror rises in money supply.

So it is no wonder that in the GDP framework, the central bank can cause real economic growth, and most economists who slavishly follow this framework believe that this is so. Much so-called economic research produces "scientific support" for popular views that, by means of monetary pumping, the central bank can grow the economy. It is overlooked by all these studies that no other conclusion can be reached once it is realized that GDP is a close relative of the money stock.

Since GDP is an empty concept obviously then once the central bank reacts to the so-called GDP growth rate it pursues arbitrary actions thereby undermining the life and well-beings of individuals.

Conclusion

In mainstream economics most key terms are ill defined. Following the view that the facts of reality cannot be known economists have adopted the framework of Milton Friedman. On this framework, the validity of a theory is assessed on how accurately it can predict the future.

This runs contrary to the view of thinkers such as Ayn Rand, Mises and Rothbard who held that the truth of man’s analysis and knowledge rests on the truth of his definitions.

The fallacious nature of mainstream economics cannot be fixed by a framework of thought that states that what matters is the accuracy of predictions of a given theory.

A theory that is based on false concepts cannot be made valid because it made accurate predictions during a particular time interval. If the foundation of a theory is flawed obviously, any forecast by means of such theory cannot be trustworthy.

  • 1. Paul Krugman, "Japan’s Trap," May 1998 at Krugman’s website.
  • 2. Milton Friedman, Essays in Positive Economics, Chicago: University of Chicago Press, 1953.
  • 3. Ayn Rand, Introduction to Objectivist Epistemology, A Meridian Book p 40.
  • 4. Murray N. Rothbard, Economic Controversies, Mises Institute P 727.
  • 5. Salerno, Joseph T. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy.” Austrian Economics Newsletter(Spring).
  • 6. Ludwig von Mises, Theory of Money and Credit, pp.32-33.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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