Barbelith Underground > Head Shop > What's so good about Market Forces, anyway?

from mises.org

What is Wrong With Econometrics?
by Frank Shostak

[Posted April 22, 2002]

A recent academic study by economists Karl Case, John Quigley, and Robert Shiller of consumer-spending behavior in the U.S. and 13 other developed nations indicates that the wealth effect from housing is twice as great on consumer spending as comparable changes in stock-market wealth. In the U.S., for example, they found that a 10-percent gain in housing prices would provoke an average 0.62-percent increase in consumption, while a similar jump in stock-market wealth only elicited about a 0.3-percent to 0.2-percent increase in spending (Barron’s, April 15, 2002).

What enabled these economists to derive these answers is econometric modeling.

In the natural sciences, a laboratory experiment can isolate various elements and their movements. There is no equivalent in the discipline of economics. The employment of econometrics and econometric model-building is an attempt to produce a laboratory where controlled experiments can be conducted.

The idea of having such a laboratory is very appealing to economists and politicians. Once the model is built and endorsed as a good replica of the economy, politicians can evaluate the outcomes of various policies. This, it is argued, enhances the efficiency of government policies and thus leads to a better and more prosperous economy. It is also suggested that the model can serve as a referee in assessing the validity of various economic ideas. The other purpose of a model is to provide an indication regarding the future.

By means of mathematical and statistical methods, an econometrician establishes functional relationships between various economic variables. For example, personal consumer outlays are related to personal disposable income and interest rates, while fixed capital spending is explained by the past stock of capital, interest rates, and economic activity. A collection of such various estimated relations—i.e., equations—constitutes an econometric model.

A comparison of the goodness of fit of the dynamic simulation versus the actual data is an important criterion in assessing the reliability of a model. (In a static simulation, the equations of the model are solved using actual lagged variables. In a dynamic simulation, the equations are solved by employing calculated from the model-lagged variables). The final test of the model is its response to a policy variable change, such as an increase in taxes or a rise in government outlays. By means of a qualitative assessment, a model builder decides whether the response is reasonable or not. Once the model is successfully constructed, it is ready to be used.

Despite the aura of importance and mysterious wisdom that econometric modeling projects, it is nevertheless an empty vessel. The econometric modeling procedure employs an untenable methodology: it tries to capture human behavior by means of mathematical and statistical methods.

Is the mathematical method valid in economics?
By applying mathematics, mainstream economics is attempting to follow in the footsteps of natural sciences. In the natural sciences, the employment of mathematics enables scientists to formulate the essential nature of objects. In short, by means of a mathematical formula, the response of objects to a particular stimulus in a given condition is captured. Consequently, within these given conditions, the same response will be obtained time and again.

The same approach, however, is not valid in economics. For economics is supposed to deal with human beings and not objects. According to Mises,

The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action.[1]
The main characteristic or nature of human beings is that they are rational animals. They use their minds to sustain their lives and well-being. The usage of the mind, however, is not set to follow some kind of automatic procedure, but rather every individual employs his mind in accordance with his own circumstances. This makes it impossible to capture human nature by means of mathematical formulae, as is done in the natural sciences.

In short, people have the freedom of choice to change their minds and pursue actions that are contrary to what was observed in the past. As a result of the unique nature of human beings, analyses in economics can only be qualitative.

Furthermore, to pursue quantitative analysis implies the possibility of the assignment of numbers, which can be subjected to all of the operations of arithmetic. To accomplish this, it is necessary to define an objective fixed unit. Such an objective unit, however, doesn’t exist in the realm of human valuations. On this Mises wrote, "There are, in the field of economics, no constant relations, and consequently no measurement is possible."[2]

There are no constant standards for measuring the minds, the values, and the ideas of men. Valuation is the means by which a conscious purposeful individual assesses the given facts of reality. In other words once an individual establishes what the facts are, he then assesses which out of these established facts are the most suitable to attain his various ends.

Individual goals or ends set the standard for valuing the facts of reality. For instance, if the goal of an individual is to improve his health, then he would establish which goods will benefit his health and which will not. Among those that will benefit him, some will be more effective than others. There is no way, however, to quantify this effectiveness. All that one could do is rank these goods in accordance with perceived effectiveness.

The use of mathematics in economics poses another serious problem. The employment of mathematical functions implies that human actions are set in motion by various factors. However, this is an erroneous way of thinking. For instance, contrary to the mathematical way of thinking, individual outlays on goods are not "caused" by real income as such. In his own context, every individual decides how much of a given amount of income will be used for consumption and how much for savings. While it is true that people respond to changes in their incomes, the response is not automatic, and it cannot be captured by a mathematical formula. For instance, an increase in an individual’s income doesn’t automatically imply that his consumption expenditure will follow suit. In other words, every individual assesses the increase in income against the goals he wants to achieve. Thus he might decide that it is more beneficial for him to raise his savings rather than raise his consumption.

The validity of probability theory in economics
While mathematics is the key tool of econometric methods, the foundation of econometrics is probability theory. What is probability? The probability of an event is the proportion of times the event occurs out of a large number of trials. For instance, the probability of obtaining heads when a coin is tossed is 50 percent. This does not mean that when a coin is tossed 10 times, five heads are always obtained. However, if the experiment is repeated a large number of times, then it is likely that 50 percent will be obtained. The greater the number of throws, the nearer the approximation is likely to be.

Alternatively, say it has been established that in a particular area the probability of wooden houses catching fire is .01. This means that on the basis of experience, on average, 1 percent of wooden houses will catch fire. This does not mean that this year or the following year the percentage of houses catching fire will be exactly 1 percent. The percentage might be 1 percent each year or not. Over time, however, the average of these percentages will be 1 percent.

This information, in turn, can be converted into the cost of fire damages thereby establishing the case for insuring against the risk of fire. Owners of wooden houses might decide to pool their risk, i.e., spread the risk by setting up a fund. In other words, every owner of a wooden house will contribute according to a certain proportion to the total amount of money that is required in order to cover the damages of those owners whose houses will be damaged by the fire. Note that insurance against the fire risk can only take place because we know its probability distribution and because there are enough owners of wooden houses to spread the cost of fire damage among them so that the premium will not be excessive. In this regard, these owners of wooden houses are all members of a particular group or class that will be affected in a similar way by a fire. We know that, on average, 1 percent of the members of this group will be affected by fire. However, we don’t know exactly who it will be. The important thing for insurance is that members of a group must be homogeneous as far as a particular event is concerned.

In economics, however, we don’t deal with homogeneous cases. Each observation is a unique, nonrepeatable event caused by a particular individual response. Consequently, no probability distribution can be established. Again, probability distribution rests on the assumption that we are dealing with a nonparticular, and so repeatable, event. Let us take for instance entrepreneurial activities. If these activities were repeatable with known probability distributions, then we would not need entrepreneurs. After all, an entrepreneur is an individual who arranges his activities toward finding out consumers’ future requirements. People’s requirements, however, are never constant with respect to a particular good. The assumption that econometrics makes--that probability distribution exists and can be quantified--leads to absurd results. For it describes, not a world of human beings who exercise their minds in making choices, but machines.

Human activities, however, cannot be analyzed in the same way that one would analyze objects. To make sense of historical data, one must scrutinize them not by means of statistical methods but by means of trying to grasp and understand how they emerged.

Econometric models have nothing to do with the reality.
Given the fact that human beings are governed by freedom of choice, the various policy analyses by means of models, known as "what if" or multiplier analyses, are little more than children’s games and cannot be taken seriously. After all, to assume that a change in government policy would leave the structure of equations intact would mean that individuals in the economy ceased to be alive and were, in fact, frozen.

Another major problem with most econometric models is that they are designed along the lines of Keynesian economic thinking. Thus the main variable in these models is gross domestic product, which is explained within the model framework by the interactions between various lumped data known as aggregates. The interaction between various aggregates in the model framework gives the impression that the economy is about gross domestic product, or about balance of payments, but not about human beings and human life. Obviously this runs contrary to the fact that everything in the human world is caused by man’s purposeful conduct.

To improve an econometric model’s capability as a forecasting tool, econometricians often employ various tricks. The predictive capability of each equation in the model is checked against actual data, and the difference between the actual data and the data obtained from the equations, also known as the add factor, is extrapolated forward and incorporated into the models equations.

In many instances the forecast produced by an econometric model is heavily influenced by the add factor which allows the model builder to force the outcome of the forecast in line with his "gut feelings." Most people are not aware of these tricks and believe that the model alone generated the outcome. All this casts a shadow on the "scientific" procedures employed by econometric modeling. Furthermore, one should not forget the suspect quality of the data out of which econometric models are constructed. In short, econometric models are nothing more than glorified play. On this Mises said,

As a method of economic analysis econometrics is a childish play with figures that does not contribute anything to the elucidation of the problems of economic reality.[3]
Conclusion
Rather than viewing econometric models as a sophisticated technique that can discover the hidden truth about the economy, we should regard them as clumsy and expensive extrapolative devices, which have nothing in common with reality. Anyone who decides to use models as an analytical tool or a forecasting device runs the risk of seriously confusing himself.

a) You are not being a wiseass, you're being childish and rude. A wiseass employs *wit*. You have no recourse but to abuse. As I say, it suggests you are not emotionally competent to handle a discussion. Basically, you sound like you're overexcited.
b) Regrettably, moderation makes the ignore button very difficult to use.
c) You keep calling everyone who disagrees with you a socialist. I do not think it means what you think it means.
d) Your "proof" so far primarily inheres in a) telling people that the Austrian school has categorically proven x, in the teeth of the fact that many economists still cleave to other opinions, b) saying that any position opposed to yours is "socialist", as if in doing so you have de facto demonstrated its inadmissability. Neither is correct or c) suggesting that anyone holding any view other than yours must not have studied the situation as deeply as you, including, of course, all those economists not cleaving to the Frankfurt School. Your refutations are reductive and unconvincing.

So:

No, I’m not “fixating” on “socialism as the enemy”. SOCIALISM IS THE BLOODY ENEMY. This can be shown theoretically, and history bears out THIS EXACT SAME CONCLUSION.

Nope. Your view of history, in which in 5-10 years the economy falls apart because nobody listens to you, bears out this conclusion. you are confusing "history" with "fantasy" and "opinion" with "fact". Your statement has no weight.

OK? And furthermore, since you have not yet grasped the FUNDAMENTALS of the debate, I don’t think we should get sidetracked just yet about the administrative details of a private property regime.

Grasping the FUNDAMENTALS here seems to mean "agree with me". Again, the statement has no weight - it's a subjective opinion of what characterises an adequate understanding of these FUNDAMENTALS. For you, entry-level is agreeing with you.

No. This is very, very VERY wrong. Capitalism and socialism ARE polar opposites. Private ownership of the means of production (market economy or capitalism) and public ownership of the means of production (socialism or communism or fascism or "planning") can be neatly distinguished. Each of these two systems of society's economic organization is open to a precise and unambiguous description and definition. They can never be confounded with one another; they cannot be mixed or combined; no gradual transition leads from one of them to the other; they are mutually incompatible. With regard to the same factors of production there can only exist private control or public control. Clear now?

Except that you have already admitted a) that every model currently used in the real world is a combination of what you call capitalist and socialist elements, although you put them all ultimately in the "socialist" bag, and b) that your ideal capitalist utopia actually *still* has elements of central control, central bodies, de facto taxation - you have failed to establish any way in which a pure capitalist society could function, and in the polarised terms of your argument have thus accepted the necessity of a socialist system.

OK, statements like this make otherwise peaceful and law-abiding citizens (namely me) want to go out and arm themselves as heavily as possible with automatic shotguns and ammo to protect myself from the ill effects of your ignorance and/or stupidity.

Blah. Nothing worthwhile is said in this paragraph.

Let’s be very clear here. There is no such thing as a market force. It is a euphemism, and a concept of limited utility (Ditto for “the common good”. Who is “the common good”? Who decides what the common good is? You?). Whoever coined the term “market force” was trying to make social science into a natural science, and should have his tongue cut out for confusing the issue for you socialists. Maybe they were trying to make economics more respectable, who knows, but we are NOT dealing with gravity here. WE ARE TALKING ABOUT INDIVIDUAL HUMAN BEINGS.

More abuse, less incentive to listen to you. If the paragraph actually contained some explanation of the shouted part at the end it might have value.

We are dealing with the decisions made by free individuals OF THEIR OWN CHOICE. So when you say things like “harness market forces more effectively for the common good”, what you are REALLY saying is that you want to harness individuals, and when you say you want to harness individuals, I start thinking that sooner or later you want to harness ME. And I don’t like being harnesses. Let’s be very clear on this. This means that you are a potential dictator and a tyrant, and you are an advocate of slavery.

It is rare that one practises a reduction ad absurdum on oneself. This is wild, lunatic extrapolation and, again, of no real consequence.

You think that your personal concept of “common good” is better than the result that can be accomplished by free individuals acting of their own volition. So not only are you evil (you are pro-slavery), but you are stupid as well since putting me into slavery WILL STILL NOT LET YOU ACHIEVE YOUR “common good” ideals (as proved by Mises).

Oh, well, if Mises said it... so far an awful lot of your argument has essnetally read "Mises said (copy and paste), so it must be true. I trust I shall hear no more dissent. It's weak, and suggests you lack the chops actually to*argue*.

Why do you think the way you do? Maybe you are not in control of your own life and therefore need to control others. Maybe you genuinely want to help people but are too ignorant to see why “helping” them by force is wrong. I would suggest that you read the Tao, for starters (the first paragraph will also conveniently help you with the use of words and euphemisms---the word is not the thing that it is describing, the tao that can be spoken and so forth). [side note…someone should start a thread comparing/contrasting Taoism with capitalism].

Bored now. More ad hominem nonsense, and still no proof or substantiation of any point made in the entire post.

You socialists are fond of saying that “what goes on between two consenting adults is none of your business” (e.g., regarding homosexuality).

Oh good - a mad ramble off. Marvellous.

This is fine. I couldn’t agree more. But the problem is that you do not then reciprocate (most notably, to people trying to trade with one another). Outside of the bedroom, you have no problem ordering people around and invading their privacy by telling them how to act/buy/transact such that the “common good” (as per YOUR individual ideal, not theirs) is achieved. Very, very, very hypocritical.

Since you have already admitted above that a capitalist society would require law, law enforcement, regulation, de facto taxation, this accusation rings rather hollow. You mean you have an acceptable *level* of control, but you still see a need to "order people around" in the interests of a doctrinaire viewpoint (that the right to property is the highest human right).

So, until you understand what is involved here, go sit in a corner with a dunce cap on with the rest of the loony socialists who have expounded these idiotic principles and caused such incredible carnage over the past couple of centuries.

More tiresome abuse, and we're still waiting for a single comprehensible, well-argued point. Of course, the Austrian school has not "caused incredible carnage"- because they have never been trusted with the mechanisms of power. You are again treating as history what is fantasy.

And while you’re at it, you should probably channel the ghosts of the HUNDREDS OF MILLIONS of dead people who have suffered death, misery, poverty, and starvation at the hands of people like you who were “only trying to help”, then explain the issues involved to them, then ask them if they really wanted your “help”, and apologize individually to each of them.

Again, nothing of worth here.

So why the guns? Your socialist philosophy means that sooner or later you are going to get around to telling me what to do with my life, or some other of my property, or trying out some insanely stupid social engineering theory on me, which means that I am your slave. And if you want to get me all fired up, try and make me your slave. And even if you DON’T tell me what to do, the angry peasants with pitchforks and torches that are miserable as a result of your lack of understanding of very simple concepts, which has made them poor and hungry, will come to burn my house down mistakenly blaming ME since I am an evil “capitalist”. This is why when people say stupid shit like this, I cringe and want to go get a gun license.

Yes, but you pay your taxes, don't you? Ergo, you are already a slave, and a hypocrite. This is where your ad hominem ends up defeating itself. While you pay taxes, use publicly-maintained roads, obey laws, you are a toadying slave to socialism. Also, once morem you are treating your Libertarian equivalent of the Rapture as if it has already happened. It has not.

Capitalism is not a form of government. That’s the whole point. Maximizing INDIVIDUAL freedom.

Fair enough. But you have already told us that your capitalist system needs regulation, so not particularly useful.

This being for many reasons:

No, this a common Marxist/socialist misconception. It will not inevitably happen. Again, wealth is constantly being created and destroyed and moved around, depending on the will of individual humans acting in their own best interest. If you are rich and don’t do a good job of serving consumers interests you will go bankrupt. If you are poor and do a good job of serving consumers interests then you will become rich. And so on and so forth.

This, too, will not inevitably happen.

Don’t get sidetracked on administrative detail of minimizing government—that is a side debate that doesn’t interest me particularly. Other people have suggesting ways without taxing and judiciaries. This is not the core debate.

It may not interest you, but it is pretty key. Obviously, you will claim not to be interested in it, because it undermines totally your argument for pure capitalism - you still need bodies placed in power over you to ensure you respect private property and other people respect yours. Some would say that you *want* to be a slave.

The whole point is to limit the destructiveness of government, not to “harness” the “market forces”. You’re going about the whole thing backwards.

So how would we... oh. That's it. Ah well.

Life is unfair. Do you think that I’m happy working as a slave for half the year so I can support a useless government beaurocrat and someone in south America I’ve never met?

As it turns out, yes. It seems you are. You just don't like the fit of this particular collar...

Is that fair? Is that equal? How come he isn’t supporting me? Again, economically this is irrelevant, because YOUR SOCIALIST METHOD WILL NOT WORK.

Te tum,. If capital letters were unstoppable, the Roman Empire would never have fallen. You are again representing speculation as fact.

No. Austrians don’t believe in the rational choice model (at least not the way you’re thinking about it). You are confusing schools of economics. They simply assert that humans are conscious (loosely termed rational) and that they act. Not that their actions have any sort of objective “rationality” as per the rational-choice school.

Ah-hah. This is a huge gap in your argumentation. You claim that we are talking about individuals, but you need people to behave as one in order to make your model of a) "socialist" apocalypse certain and b) capitalist utopianism workable. At the heart of your argument you have to represent people as simultaneously capital-handling individuals and as an undifferentiated mass who, provided with pure capitalism will LIVE IN PLENTY and if kept in socialist slavery will BURN, BURN AND DIE.

In essence, you don't _have_ an argument in this post. You have a few unproven assertions hung on a future vision that you have yet to demonstrate conclusively is inescapable (and if you can do this, might I suggest doing it to the UN?), tacked ineptly onto a lot of shouting and insults. I don't know why Leaptopians can't handle intelligent conversation, but there we go. Does this form of proselytising ever work?