Assumptions Matter Both in Economics and in the Real World

To explain Japan’s economic problems, Paul Krugman employed a model that assumes people are identical and live forever. While admitting that the model is not realistic, Krugman nonetheless argued that his model could still offer solutions to the crisis.

In The Philosophical Origins of Austrian Economics, David Gordon wrote that Eugen von Böhm-Bawerk believed economic concepts must originate from reality and should be traced to their ultimate source. If one cannot trace them to their source, the concepts are meaningless.

Similarly, Ayn Rand suggested that concept formations are not arbitrary. The role of concepts is to integrate relevant existents, while the role of definitions is to identify the essence of the 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 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.

She adds: “The truth or falsehood of all of man’s conclusions, inferences, thought and knowledge rests on the truth or falsehood of his definitions.”

Milton Friedman declared that assumptions in various economic models can be detached from reality, writing:

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.

This way of thinking says our knowledge of economics is ambiguous. Since one cannot establish “how things really work,” the underlying assumptions of a theory don’t matter.

Do We Know Something about Ourselves?

Contrary to popular thinking, economics is not about gross domestic product, the consumer price index, or other economic indicators but about human interaction. For instance, one can observe that individuals are engaged in activities such as performing manual work, driving cars, or taking a walk, all actions being purposeful.

Furthermore, we can establish the meaning of these actions. Manual work may enable some people to earn money, allowing them to achieve goals like buying food or clothing. Dining in a restaurant may lead to the establishment of business relationships, and driving a car helps one to reach a destination.

The fact that individuals consciously pursue purposeful actions provides us with definite knowledge, setting the basis for coherently assessing an economy. Ludwig von Mises writes:

The physicist does not know what electricity “is.” He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process.

Physicists cannot directly verify assumptions because they know nothing directly of the explanatory laws or causal factors. In economics, however, human action is conscious and purposeful and not tentative. Anyone objecting to this concept contradicts himself, since he is engaged in a purposeful and conscious action to argue that human actions are not conscious and purposeful.

Knowing that people act purposefully permits us to evaluate the popular mainstream view that the “engine” of an economy is consumer spending driven by demand. We know that one cannot meet goals without means. However, means do not emerge out of nothing, as tools and machinery must first be produced. Contrary to popular thinking, the driving force is supply and not demand, since one’s demand is constrained by the ability to produce goods. The more one produces, the more goods one can demand.

In contrast, most economists believe the central bank should increase monetary pumping in response to an economic downturn. Money cannot promote real wealth generation, since it is simply a medium of exchange. Instead, increasing the supply of money undermines the wealth-generation process and leads to the boom-bust cycle. According to Murray Rothbard: “Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.”

Is Predictive Capability a Valid Condition for Accepting a Theory?

The popular view that predictive capability determines the validity of a theory is incorrect. We can confidently say that 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 theories of supply and demand but does not mean these theories are incorrect because they cannot predict the future price of bread.

Mises writes:

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.”

Why Arbitrary Concepts Undermine Individual Well-Being

The arbitrary process of forming assumptions in economics should not be taken lightly. Rothbard writes:

But false assumptions are the reverse of appropriate in economics. For human action is not like physics; here, the ultimate assumptions are what is clearly known, and it is precisely from these given axioms that the corpus of economic science is deduced. False or dubious assumptions in economics wreak havoc . . .

For example, the central bank is required to pursue “price stability,” with the price level being a weighted average of prices of selected goods and services. From this, one can also infer that the average purchasing power of money is a weighted average of the purchasing power of money with respect to various goods and services.

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

Arithmetically, one cannot add up two potatoes to one loaf of bread in order to establish the average purchasing power of a unit of money with respect to bread and potatoes. If we cannot ascertain what something obviously is, it is not possible to keep it stable. A policy that is aiming at stabilizing a fiction can only lead to a disaster.

Conclusion

Conscious and purposeful conduct emanates from human beings. Consequently, in economics, we know and don’t assume. A theory based on assumptions that are detached from reality cannot be made valid simply because it generated accurate predictions during a particular time interval. Economic truths are immutable, not temporary.