This article was originally published by Frank Shostak at The Mises Institute.
For most analysts, if the gross domestic product (GDP) data shows an increase, then this is perceived as good economic news. Conversely, if the GDP data shows weakness, then this is regarded as a possible deterioration in economic conditions. Most analysts are data-driven. The reality for them is what they see.
Thinkers such as Ludwig von Mises questioned this way of assessing the state of the economy. For Mises, data is an historical display and, by itself, cannot provide the analyst with a genuine understanding of the nature of economic phenomena. He wrote,
Experience of economic history is always the experience of complex phenomena. It can never convey knowledge of the kind the experimenter abstracts from a laboratory experiment.
According to Mises, the economist must have a theory beforehand in order to make sense of the data.
The Role of a Theory
Contrary to much popular thinking, economics is not about GDP or the CPI or any other economic indicator, but about human action, choices, and social cooperation. For instance, one can observe that people are engaged in a variety of activities. They perform manual work, drive cars, walk on the street, and dine in restaurants. The distinguishing characteristic of these activities is that these activities are purposeful or goal-oriented. Individuals operate within a framework of ends and means; they use means in attempts to secure ends.
Purposeful action implies that individuals assess or evaluate means at their disposal against ends. At any point in time, individuals have an abundance of ends that they would like to achieve. What limits the attainment of ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be secured.
Human Action, Data, and Theory
During an economic slump, a general decline in the demand for goods and services can be observed. Are we then to conclude that the decline in demand is the cause of an economic recession?
We know that most individuals are constantly employing scarce means to accomplish subjective-valued ends. Due to scarcity and subjective choices, it is quite likely that the observed decline in the people’s general demand is because of their inability to support their demand. Problems on the production side (i.e., with means) are the likely causes of an observed general decline in demand.
The knowledge that individuals are acting to achieve ends permits us to evaluate the popular thinking that holds that the “motor” of the economy is consumer spending—i.e., demand creates supply. We know, however, that without means, no goals can be met. Most means do not emerge out of the blue; means have to be produced first. Hence, contrary to popular thinking, the driving force is supply and not demand.
The knowledge that people pursue purposeful actions is not tentative; it is always valid. Anyone attempting to suggest that this is not the case is engaging in contradiction, since those who argue against human action are, in fact, engaging in purposeful human action.
An analyst looking at data without a theory cannot provide reasons for changes in the data. All that he can do is just describe the changes in the data. Ironically, any interpretation of data necessarily presupposes a theory.
Quantitative analyses also cannot establish the meaning of a particular economic phenomenon. All that quantitative analysis of the data can do is report information. Quantitative analyses cannot explain why people are doing what they are doing. Without the assumption that human actions are purposeful, it is not possible to make sense out of the historical data.
The Importance of Defining the Subject of Investigation
In the analysis of historical data, the key is to establish the definition of the subject of the investigation. The purpose of the definition is to ascertain the key factors that determine the subject of investigation. To form a definition, it is helpful to go back to the beginning. For instance, in order to establish the definition of money, we should go back to the point in time when a particular good started to assume its role as money.
Historically, many different goods have been used as the medium of exchange. Mises observed that, over time,
. . .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.
By ascertaining the commodity that was selected as money, we establish that this commodity fulfills the role of the general medium of exchange. This means that individuals are paying for one good with another good with the help of money.
We can also establish that increases in the quantity of money (i.e., inflation) generate a decline in the purchasing power of money, all other things being equal. This is because inflationary increases in money supply result in a greater quantity of money per unit of a good than in the previous situation, all other things being equal.
To reach this conclusion, we have to define prices. Now, a price is the voluntary agreement to exchange certain amounts of goods; in a monetary economy, a price is usually the amount of monetary units exchanged per unit of a good. Hence, by observing an increase in the money supply, one can infer that, all other things being equal, more money will be spent per good and prices will increase. This necessarily also involves a decline in the money’s purchasing power.
The definition of money as the general medium of exchange enables us to establish that, once money is inflated, it is not spread instantaneously across all the markets; it starts with some individuals. The money moves from one individual to another individual and from one market to another market. We can also infer that changes in the money supply exert an effect on the prices of goods with a time lag.
In the modern world of the paper money standard, we can establish that an increase in the money supply results in an exchange of nothing for something. It leads to a diversion of wealth from wealth-generators to non-wealth-generating activities.
Without a theoretical framework, isolated data cannot tell us the conditions of the economy. Data cannot tell us whether a strong GDP is due to the wealth expansion or a result of the erosion in the wealth-generation process.
Many mainstream economists say that, by means of various mathematical and statistical methods, it is possible to establish the causes and effects in the world of economics. In other words, to develop an empirical theory from the data. But the fact that individuals pursue purposeful actions implies that causes in the world of economics emanate from human beings. This means that quantitative methods are not helpful here. It is not possible to quantify individuals’ minds.
Conclusion
Gazing at the economic data in order to form a view about the state of the economy without a theory is pointless. Economic data without a theory cannot provide the foundations for a sound economic theory. Instead, a valid theory must be presupposed.
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