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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