Wednesday, September 12, 2012

Econometrics: A House Built on Sand

24 Therefore whosoever heareth these sayings of mine, and doeth them, I will liken him unto a wise man, which built his house upon a rock:

25 And the rain descended, and the floods came, and the winds blew, and beat upon that house; and it fell not: for it was founded upon a rock.

26 And every one that heareth these sayings of mine, and doeth them not, shall be likened unto a foolish man, which built his house upon the sand:

27 And the rain descended, and the floods came, and the winds blew, and beat upon that house; and it fell: and great was the fall of it.

Econometrics is "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations."  More precisely, it is "the quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation, related by appropriate methods of inference."  An influential introductory economics textbook describes econometrics as allowing economists "to sift through mountains of data to extract simple relationships."

Econometrics is the unification of economics, mathematics, and statistics. This unification produces more than the sum of its parts.  Econometrics add empirical content to economic theory allowing theories to be tested and used for forecasting and policy evaluation.

Econometrics is the tool that purports to give quantitative credibility to the science of macro-economics, making this science more useful for recommending policy.  I use the words “credibility” and “science” loosely.  I use the word “purports” rather purposefully.  I use the word “policy” to mean central planning.

Hayek addressed the shortcomings of such tools in the field of economics.  In his lecture on the occasion of his being awarded the Nobel Prize, he spoke to “The Pretense of Knowledge.”  The shortcomings he points out are quite valid, and can be summarized as follows (in his own words): 

This brings me to the crucial issue.  Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones.  While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable.

And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

It should be clear, especially after the fatal catastrophe of 2008, that economists are no better at their science today than they were when Hayek spoke these words in the mid-1970s.  Like the foolish man who built his house upon the sand, once the rains came the house built by the macro-economist depending on his mathematical tools was washed away.

Hayek’s criticism combined with the failures of economists in his time and the greater failures in our time should be enough to bring humility and shame on the profession – and certainly to discredit the idea that human action can be modeled.  However it is not solely based on Hayek’s criticism that I suggest econometrics is a house built on sand.

Hayek rightly points out that there is much activity that is not captured by data; he further points out that economists then turn to the data they have and say “welcome, you must be the only important data.”

I will suggest even much of the data to which economists have access cannot be used for the stated purpose of econometrics, and therefore are of no use for the purpose of policy recommendations (assuming such central planning was desirable in the first place.  I do not.).

To this end, I will focus on one simple variable: GDP.  The same arguments can be made for any variable attempting to capture the “wealth” of a given society.  I can think of no purpose for economics if it isn’t to identify the means and methods that will offer the possibility for the greatest wealth creation for the individual – and in the macro-economist’s case, for society.

I begin with subjective value: 

The subjective theory of value is a doctrine of value which advances the idea that the value of a good is not determined by any inherent property of the good, nor by the amount of labor required to produce the good, but instead value is determined by the importance an acting individual places on a good for the achievement of their desired ends.  This theory is one of the core concepts of the Austrian School of Economics, but is also accepted by most other "mainstream" schools of economics.

Any specific good will be valued differently by two individuals.  The same good might be valued differently by the same individual at two different times.  The same good might be valued differently if it represents the thirtieth such good in an individual’s possession as opposed to the first such good.

Take a simple example.  I walk into the shop to buy a candy bar.  I give the shopkeeper a dollar; he gives me the candy bar.  It must be so that I valued the candy bar more than the dollar while the shopkeeper valued the dollar more than the candy bar.  We both had to feel the trade would improve our condition, else we wouldn’t have traded.

Why would I go to the effort to go to the shop in order to get back an item that brought me no greater value than that which I was prepared to give?  Why would the shopkeeper establish his business only to receive in value the equal of what he gives?

Neither actor would do so.  The trade is not equal value for equal value.  Each of us believes we have reached an improved position as a result of the trade.

Such transactions are the basis for economic life.  Statistics and data – GDP, employment, profitability, etc., all are aggregates of the countless billions of individual transactions such as the simple one above.  To the macro-economist, this transaction would represent one dollar of GDP.  With this transaction and the countless others like it, he now has the basis for modeling.

But to the two actors this trade represents something different, and something not measurable.  First, consider the trade.  The economist will suggest that there was an increase of activity by one dollar.  But for the two actors, there was nothing more than an exchange.  Each one received that which he valued.  There was not a gain of one dollar as a result of the transaction – one traded a dollar and received the candy bar; the other traded the candy bar and received the dollar.  Would we say there was a net gain to society of a candy bar?  Of course not.  The gain isn’t in the dollar – it is in the trade, and specifically the subjectively-valued gain made by each participant because of the trade.

Second, then, what is the value of the “gain”?  This is unknown.  Nowhere is it recorded how much “gain” the customer received.  Value is subjective, it isn’t quantified, the gain isn’t recorded, and the exact amount is likely not known even to the customer.  Did he gain twenty cents worth of value?  Forty cents?  He likely doesn’t know, and even if he does, the economist doesn’t know.

Then there is the value “gained” by the shopkeeper.  All the same questions apply.

In a free-trade, both actors gain.  The gain is not measured in the currency unit of the trade; the gain is unknown – likely even to the actors themselves.  But it is through such trade that wealth is created – not the wealth represented by the dollar (the customer does not feel poorer after the trade, else he wouldn’t have traded), but the wealth of the subjective value gained by each actor.

Each actor is wealthier, yet this is not captured in GDP, or in any other statistical measure of “wealth” or “activity.”  The quantitative value is not measurable, yet economists have built sophisticated models purporting to derive relationships useful for making policy recommendations.  Yet they have no way to capture the only point of any actor making a trade, and that is to increase his wealth.

Consider another example.  The government taxes my dollar and then gives it to someone else to spend.  Here again, GDP has increased by one dollar.  In this case, however, the recipient of my dollar feels wealthier while I feel poorer.  There is no net gain of wealth as there is in the free market trade; in fact there is likely a net destruction due to the loss of respect for private property in this example.  Yet this transaction has the same “value” of one dollar in the econometrician’s model.

Even if the economist somehow makes adjustments for these two different types of transactions, it does nothing to solve the issue that the gain to each participant (or the loss to the one who was taxed) is unknown and unknowable.  I can think of a no more fundamental question for economists to solve – that being how to increase wealth – yet it is not addressable by the econometrician, therefore the mathematical modeling is of no use for the macro-economist.

Yet, to a true adherent of the theory of subjective value, the question of how to increase wealth is quite solvable: any trade that happens in a free and un-coerced manner increases the wealth of both actors.  It cannot be measured, and does not have to be measured to be proven.  If the participants freely make the exchange, they do so only because they believe they will be in a better position after the trade than before.

This is the house built upon a rock.  As long as trade is free, wealth will be created and increased.

Hayek has suggested that not all of the important variables are captured by the economist, or even can be captured.  I suggest that even the variables that are captured are useless for the purpose applied.  I have suggested before that government-policy recommendations based macro-economics is quackery.  I find no reason to change this view, other than now to suggest it is a house built on sand.

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