In Praise of Theory

Econophile's picture

This originally appeared in The Daily Capitalist.

This is an article I did for a local newspaper for which I write a regular column on economics. Size limitations required the article to be very concise, thus a philosophical treatise on theory, epistemology, and intellectual trends was not possible. But I think it came out well. What do you think?

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Why is the economy a mess? Why can’t our leaders fix it? Why can’t we get good people to go to Washington to fix things? Why can’t we just pick the “best” ideas from all sides and get this thing fixed? I get asked these questions frequently.

I have an answer but it is not what you may be expecting.

The answer is not that we don’t have good, smart people trying to solve our problems. Obama’s staff is stocked with capable, bright people including Secretary of the Treasury Tim Geithner, and Austan Goolsbee, the new chief economic adviser. Fed Chairman Ben Bernanke, a Republican, is one of the smartest people you would ever meet. He received his Ph.D from MIT. He was a professor of economics at Princeton. He is a great admirer of Milton Friedman, the revered founder of Monetarist economic theory and a fierce defender of free markets.

The recently departed chief economic adviser to the Obama Administration, Larry Summers, has a Ph.D in economics from Harvard. He is the son of two well known economics professors and his uncles are Nobel laureates, Kenneth Arrow and the late Paul Samuelson.

Say what you will, but they are the cream of mainstream economics, they all have the best of intentions, and they very much want to solve our economic problems. After all, their boss’s job depends on it.

The answer to the above questions is this: the economic theories of the cream of mainstream economists are wrong.

If real world results can be used to measure cause and effect, then we have proof in the sad state of our economy that they are wrong. Their solutions are wrong because their ideas are wrong and their ideas are wrong because their economic philosophy is wrong.

This is where I really hope to capture your attention even though I am getting into things philosophical. Most “practical” people dismiss “theory” as just the musings of ivory tower types. They eschew theory for “common sense.” This attitude is wrong for it is the academic theoreticians who have captured the commanding heights of ideas, especially in economics. They have changed the world, and that is real power.

You can only refute bad theory with good theory. Good theory can be counter-intuitive to what seems “common sense” or “pragmatic.” I don’t mean to be dismissive of common sense, but Einstein referred to it as just a bunch of prejudices we have formed by the age of 18.

Economic theory is a complex topic, but bear with me for a moment, I have a point.

The theory or philosophical foundations behind mainstream economics is the belief that (i) studying aggregates of data (like GDP) reveals truths and can predict economic behavior, (ii) people act rationally thus you can design mathematical formulas to determine the best policies to affect such behavior, and (iii) the government can effectively carry out these policies.

All of their principles, solutions, proposals, studies, and policies are founded on these rocks. I have greatly simplified a complex topic, but I do so to make a point.

It may seem to you that these theories are fine so what is the big deal? It is a big deal because the solutions these theories have spawned have failed in the real world and the economy is in trouble.

Mainstream economics ignores human nature. They think they can effectively direct collective human behavior because we are “economic units” and by studying masses of data they can devise mathematical formulas to “correct” our actions. This is called the “science” of econometrics. It is not that the study of data itself is bad, but the idea that it is predictive is false. I can look at the output of certain data and get an idea of what auto production is, but I can’t tell you what auto you will buy tomorrow. Econometrics is the farthest thing from a hard “science.” Free market economists Mises and Hayek called it a fake science. (See Hayek’s Nobel Prize lecture.)

A number of free market economist-philosophers, such as Mises and Hayek, have come up with a completely different view of the economic world. Instead of treating us as aggregate economic units, they examine our behavior as individuals. After all, the “economy” is just the result of hundreds of millions of individual choices made every day.

These free market economists believe the proper basis of economics is to study how individuals make decisions and interact in an imperfect world. They don’t believe it is possible to predict human behavior by studying aggregates because aggregates don’t make choices, only people do, and those choices are based on personal values, emotions, and feelings, things that are subjective and immeasurable. It takes into account that we don’t always act rationally and that markets aren’t perfect.

It gets very complicated from here so I will stop with the philosophy. If you want proof, then know that free market capitalistic countries have been the most successful in the world.

If you accept the fact that mainstream economists failed to see the obvious coming, that they have failed miserably to revive the economy yet they continue to use the same failed policies, then wouldn’t you agree we need change?

We can only change the direction of our country by challenging the foundations of mainstream economics. And that is why theory is so important.

Very, very few mainstream economists have bothered to study the intellectual foundations of economics. They have been spoon-fed this mechanistic econometric view and do not have the intellectual training to contradict it. The fact is that much of academia is a closed society hostile to ideas that contradict conventional wisdom. That too is human nature.

How can we effect change? By respecting and praising theory. By respecting the work of academic theoreticians. By working to bring free market theories to light. By donating money to institutions which support free markets. By supporting the publication of books by free market theoreticians. By supporting free market educational programs. By educating ourselves about the richness of philosophy. By not taking the easy way out by looking for expedient solutions. By voting for politicians who respect ideas and the power of freedom.

And that is why I write.