Methodology for Introduction to Austrian Economics

Methodologyfor Introduction to Austrian Economics By Paul F. Cwik, Ph. D.Mount Olive College & The Foundation for Economic Education

Most Economists Don’t Care • Most economists are not concerned with the methodology of economics. • Austrian economists tend to be much more interested in methodology. There is a disparity. • Unfortunately, when Austrians confront mainstream economists on methodological issues, we are not scoring many points. • Even if the Austrians completely beat every opponent’s methodological argument, I wouldn’t expect to see a wave of converts to the Austrian approach. • Nevertheless, there is merit for doing the science correctly. Their response is indifference. Many just don’t care. “Let me teach my class.”

Menger vs. the German Historical School (GHS) • Menger’s economics had two major elements: • Methodological Individualism • Methodological Subjectivism • There was a strong negative reaction by German professors to his idea that these elements are universal. • The GHS rejected Menger’s ideas and, instead, were in favor of the “doctrine of internal relations.” • This doctrine says that everything influences everything else. • However if all things are connected, then in order to gain full knowledge of anything, we need the knowledge of everything. • For the GHS, looking at anything separately or in isolation (e.g., using ceteris paribus) is completely illegitimate.

The Doctrine of Internal Relations • This doctrine states that before we can know or understand anything, we need to see the total picture. • The total picture is necessary because everything influences everything else. Looking at a topic in isolation is to ignore these greater relationships. • Economics is not separate from history, political science, ethics, and so forth. • The best approach is that we pick topics like: prices, wages, production, banking, inflation, the business cycle and describe as much as we can observe. • The more information that we gather, the better understanding we will eventually have. • The flaw of this approach is that it is unsystematic and does not follow deductive reasoning.

Methödenstreit • Menger published his Investigations Into the Method of the Social Sciences in 1883, and Gustav von Schmoller wrote a review of Menger’s book. • As you can guess, Schmoller did not have a favorable review. • In 1884, Menger responded with a (never translated into English) pamphlet: “The Errors of the German Historical School.” • The German Historical School (GHS), although divided, shared a common belief that: There were no universal laws of economics applicable for all men, at all times, in every country. • The GHS called the Classical Economic Theories, “English Political Economy.” • They argued that each historical period has its own laws of economic relationships and that these “laws” of economic relationships are relative to the historical epoch of that moment. • These laws change as the historical period changes.

Methödenstreit continued • For the GHS, the German nation and people had their own history, their own historical stages of development and therefore, their own “laws of economics.” • England could argue that it was good for them at that time to follow a path of free trade, but Germany, in its own historical stage and “economic laws” required protectionism and governmental intervention. • For the GHS, what was the purpose of theory and policy on the basis of that theory? • The answer is to serve the interests of one’s nation, to make it strong and progressive. • The GHS accepted the socialist argument that class tensions existed and also accepted the mercantilist argument that the interests of the individual might not be harmonious with the national interest. • Hence, the State has to intervene in economic and social affairs to minimize class tensions and to regulate individuals in their economic activity to make their actions consistent with the “national interest.”

Methödenstreit continued • The GHS and Schmoller argued that the laws of economics were historically determined. Each stage of a nation’s history dictated and required different economic relationships and institutional rules (for contracts, for property rights, etc.). • Schmoller parted ways (from the GHS) and argued that there were no historically dictated stages of predetermined evolution. There was just the process of history. All one could do was sift through the historical artifacts of previous stages of a nation’s history and “the facts” (institutional, legal, technological, cultural) of one’s own time, and out of this “discover” the theory – the “law of economics” that seems to be prevailing for this time. • As a result, Schmoller called for “just relationships” (that’s just as in Justice) as defined by himself. He advocated the state cartelization of industry, the establishment for welfare programs for the lower classes, and, in general, the state must act as a paternalistic agent for everyone in the nation. • This is what Menger was up against when he waged essentially a one man battle.

Menger Argues in Favor of Social Organic Structures How can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them? – Menger (1883) • For Menger, social institutions and social phenomena are the result of individuals acting and are not the result of a collectivist design. • They are unintended results. • Menger labeled them as “organic social structures.” • Menger asks…

Law, language, the state, money, markets, all these social structures in their various empirical forms and in their constant change are to no small extent the unintended result of social development. … Also, understanding of them cannot be “pragmatic” in the cases considered here. It must be analogous to the understanding of unintentionally created social institutions. The solution of the most important problems of the theoretical social sciences in general and of theoretical economics in particular is thus closely connected with the question of the understanding the origin and change of “organically” created social structures. – Menger (1883)

Organic Social Structures include… • Language, • Laws, • Morals, • Markets, • Money, and • Towns. • Most importantly, Menger demonstrates that you should start with individuals and their interests. • It is from an analysis of individuals’ incentives that we can build up the story of the origin of and the importance of these organic social structures. • I think that Menger eventually wins this battle, but it might not be because he out argued his opponents and everyone agreed with Menger. • I will hold off on answering “why,” but I think Wieser was right.

Modern Positivism / Empiricism • This approach is followed by the mainstream. • It starts by dividing economics into positive economics and normative economics. (You’ll see this in Chapter 1 of most textbooks.) • Positive Economics is independent of any particular ethical position. • “What is?” • Normative Economics does consider the ethical side. • “What ought to be?” • Any normative or policy position needs to be founded on Positive Economics, or what they call “theory.”

Modern Economic “Theory” • In 1953, Milton Friedman wrote on methodology and for the mainstream it all starts and ends there. • The goal of positive economics is to create a theory that “yields valid and meaningful predictions.” – Friedman (1953) • “[T]heory has no substantive content; it is a set of tautologies. Its function is to serve as a filing system for organizing empirical material and facilitating our understanding of it.” – Friedman (1953) • Theory needs to be connected to the real world by empirical observations to gain any meaning.

Scientific Method: Observe data/event Recognize correlations Speculate Causation (Construct a Theory) Create a Hypothesis (Yes/No) Test—Controlled Experiment Revise Theory Austrian Economics is different. We use Axiomatic Deductivism: Axiom Laws Theorems Models Thought Experiments Modern Economic Methodology Does the Scientific Method work for the Social Sciences? The Austrians say, “No.” We are going to examine what each side says and then you can decide which side you agree (or at least disagree) with. Remember: We need to use the ceteris paribus condition. These thought experiments allow us to hold everything else constant.

Empiricism needs Testing • Prediction is necessary to distinguish causes. • We know what has occurred, but to distinguish the validity of one theory over another, the applicability to future events becomes paramount. • “Viewed as a body of substantive hypotheses, theory is to be judged by its predictive power for the class of phenomena which it is intended to ‘explain.’ Only factual evidence can show whether it is ‘right’ or ‘wrong’ or, better, tentatively ‘accepted’ as valid or ‘rejected.’ … Factual evidence can never ‘prove’ a hypothesis; it can only fail to disprove it, which is what we generally mean when we say, somewhat inexactly, that the hypothesis has been ‘confirmed’ by experience.” – Friedman (1953)

Results from Testing • Friedman correctly points out that testing never proves or disproves an economic relation. • What happens is that we are reducing the probability that something is false. • As an aside, it should also be noted that probabilities are not truth. • Furthermore, the assumptions need not be realistic. • All that matters is the predictive power of the hypothesis.

Criticisms of Empiricism • What should we measure? • How do we know if we have a collaborative or falsifying result? • How do we measure? • There are no constants in economics, unlike the speed of light in physics. • How do we measure utility? • (What’s a util, anyway?) • Empiricists only observe; they do not engage in introspection.

Empiricism is Self-Contradictory • Empiricism starts with, “A statement must be verifiable with empirical evidence, otherwise it is merely definitional and tells us nothing about the real world.” • (Recall that Friedman said, “[T]heory has no substantive content; it is a set of tautologies.”) • However, this beginning statement is not something that can be empirically verifiable. • Nevertheless, the statement is attempting to tell us about the structure of reality. • It is contradicting itself. • Either the statement that all knowledge must be verifiable is an empty tautology and “has no substantive content,” • or it, too, must be subject to falsification. So why should we adopt the verification principle?

Mises’ Response • If Empiricism is defined this way, then Mises was right to say, • “[I]f one accepts the terminology of logical positivism … a theory or hypothesis is unscientific if it cannot be refuted by experience. Consequently, all a priori theories, including mathematics and praxeology are ‘unscientific.’ This is merely a verbal quibble.” – Mises The Ultimate Foundation of Economic Science • If someone wants to define “meaning” so that the conclusions of praxeology are meaningless, why should he (and other praxeologists) care? • For Mises, praxeology is built upon a foundation of truth and from that foundation can be deduced meaningful economic statements.

Introspection is the Key • The Natural Sciences observe and attempt to infer reality from their observations. • They never ask the pen why it falls. • The Social Sciences have an advantage over the Natural Sciences. • We don’t have to merely observe the world around us. • We can ask, “Why did we (you) do that?”

The Use of Deduction • Deduction allows us to start with a Truth and obtain other true statements. • A Valid Argument is a correct conclusion derived from premises. • An invalid conclusion means that at least one of your premises were not true.

The Use of Inference • An inference is a part of the reasoning process. • We can start with a statement like this: • “All socialists are subversives.” (Thanks to David Gordon for this example.) • And change it to “All fatheaded socialists are fatheaded subversives.” • Math does the same thing: • If x = 5, then • 2x = 10. • In mathematics, once you know the rule you can always apply it.

The Use of Inference • However, inference does not have a hard rule in the social sciences like it does in mathematics. • For example: • “All socialists are subversives.” • “Therefore, all Russian socialists are Russian subversives.” • This conclusion is not true. The Russian Socialists might be Ukrainian subversives. • There is no mechanical rule that tells us which immediate inferences work and which do not. • Therefore, the use of mathematics needs extreme care. • For example, M ∙ V ≡ P ∙ Q does not equal 2M ∙ V ≡ 2P ∙ Q.

Should We Use So Much Math? It is a great fault of symbolic pseudo-mathematical methods of formalising a system of economic analysis … that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed…. Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. • If you look at an Austrian journal article and compare it to a mainstream article, you would not think that they are in the same field. • The mainstream approach is highly mathematical, while the Austrian is significantly less so. • Who said the following? John Maynard Keynes The General Theory, (1936) p. 297-8.

Jean-Baptiste Say, A Treatise on Political Economy (1834): “The study of statistics may gratify curiosity, but it can never be productive of advantage when it does not indicate the origin and consequences of the facts it has collected; and by indicating their origin and consequences, it at once becomes the science of political economy.” “A perfect knowledge of the principles of political economy may be obtained, inasmuch as all the general facts which compose this science may be discovered. In statistics this can never be the case….” “Political economy [is] … whenever the principles which constitute its basis are the rigorous deductions of undeniable general facts, rest[ing] upon an immovable foundation.” “Political economy…is composed of a few fundamental principles, and of a great number of corollaries or conclusions, drawn from these principles.” Jean-Baptiste Say’s Approach

Nassau Senior, An Outline of the Science of Political Economy (1836) “[P]remises consist of a few general propositions, the result of observations or consciousness, and scarcely requiring proof, or even formal statement, which almost every man, as soon as he hears them, admits as familiar to his thoughts, or at least as included in his previous knowledge; and his inferences are nearly general, and, if he has reasoned correctly, as certain as his premises.” Also, economists should be “aware that the Science depends more on reasoning than on observation, and that its principle difficulty consists not in the ascertainment of its facts, but in the use of its terms.” Nassau Senior’s Approach

John E. Cairnes, The Character and Logical Method of Political Economy (1857) “[While] mankind have no direct knowledge of ultimate physical principles…the economist starts with a knowledge of ultimate causes.” “The economist may thus be considered at the outset of his researches as already in possession of those ultimate principles governing the phenomena which form the subject of his study, the discovery of which in the case of physical investigation constitutes for the inquirer his most arduous task. … Conjecture [in economics] would manifestly be out of place, inasmuch as we possess in our consciousness and in testimony of our senses…direct and easy proof of that which we desire to know. In Political Economy, accordingly, hypothesis is never used as a help toward the discovery of ultimate causes and laws.” John E. Cairnes’ Approach

I do not claim that this is the only method for Austrian economics. However, I think that this approach is the most correct. Even if you disagree with it, I think that there are insights here that will deepen your understanding of economics. Mises proposes that we use the term “Praxeology” (the logic of action) for the branch of knowledge that includes economics. Misesian Praxeology

Axiomatic-Deductivism • We start with an Axiom, something that is universally true. • There are many true propositions, but the starting point is the Human Action Axiom. • Axiom of Human Action—is that people behave purposefully over economic (scarce) goods. To satisfy our wants and desires, we act. • However, not all goals or wants can be satisfied at once. This is due to Scarcity. Scarcity is an assumption.

Mises was not a Kantian, however he does use Kant’s categories. The first division is between: Analytic vs. Synthetic Analytic means that formal logic, all by itself, is sufficient to determine truth. Statements that are Synthetic need something else. Immanuel Kant’s Categories

Kant’s Second Set of Categories • The second division of categories is between: • A Posteriori vs. A Priori • A statement that is a posteriori means that observations are necessary in order to establish or confirm its truth. • A statement is a priori if observations are not necessary for establishing or confirming its truth. • For example, 1 + 1 = 2 is an a priori statement.

Synthetic A Priori Statements • A synthetic a priori proposition is a statement whose truth-value can be definitely established and observations are unnecessary, however only using formal logic is insufficient. • (According to Kant, mathematics and geometry contain examples of true synthetic a priori statements.) • So, how do we find a truth where observations are unnecessary, but logic is insufficient? • Observations reveal things as they happen to be; there is nothing in them that show why things are as they are. • We need something deeper. • The Human Action Axiom fulfills these requirements.

Human Action, Synthetic A Priori? • The Human Action Axiom is something that does not need to be observed. We rely on introspection. • The Law of Self-Contradiction shows that its negation is false. • Suppose that you argue that people do not behave purposefully. • What has happened? • You are purposefully arguing that people do not behave purposefully. • You have contradicted yourself. • Supposing that we agree with the a priori part, then what about the synthetic part? What about the part where logic is insufficient?

Creating Economic Theory • In order to fulfill the synthetic requirement, we need more. • We need some assumptions. • For example, we live in a world of scarcity, and • we live in a world that uses money. • We create an Means/Ends framework. • Action uses Means to achieve an End. • The Means and the Ends must be achievable. • It should also be noted that not all goals lead to actions. • From this process we can deduce the law of demand and the law of supply. • The combination of these laws with specific assumptions lets us conduct Thought Experiments.

Theory vs. History • Understanding the world around us, or comparing one theoretical world with another, is the province of theory. • In other words, it is through theory that we examine the world around us. • We apply theory to the facts. We interpret the facts through the knowledge of theory. • Empirical observations do not confirm or deny theory. • Econometrics is a technique of analyzing the data. • Econometrics looks at history. • However, history does not explain theory.

Application of Praxeology • Economics is not able to predict like the Natural Sciences do. • E.g., Natural Science accurately predicts the tides. • What economic theory allows us to do is limit possible reactions/outcomes that are possible. • If something falls outside of what we predict (suppose the increasing of the minimum wage is followed by a decrease in unemployment), • then we have missed something in the application of our theory. We missed something in one of the subsidiary assumptions.

Prediction with Praxeology • In general, we should expect to see the economist who uses praxeology to have a better track record at predicting events than one who doesn’t. • In order to make better predictions, we need more assumptions and more accurate assumptions. • However, this increase in the amount and extent of the assumptions diminishes the scope of applicability of the predictions. • (Furthermore with the addition of corollary assumptions, our conclusions are no longer apodictically certain.) • It is through this process that Austrians (or more specifically, praxeologists) “do economics.”

Hayek didn’t think that Mises’ Praxeology was sufficiently grounded in the real world. Hayek claimed: All statements about the world are abstractions. Action needs to take place in the real world. Hayek’s View

Karl Popper was a colleague of Hayek’s at the LSE. Popper said that in order to be considered scientific, a statement needed to be open to “Empirical Falsification.” Popper’s falsification argument is more than a trivial difference from positivism. Popper argued that confirming a position does not add to the probability that it is true. No matter how many times we confirm through empirical observation that demand curves slope downward, the chances that this statement is true has not increased. Hayek was influenced by Popper

Wieser’s View • During the methödenstreit, Menger was at the forefront. • Böhm-Bawerk also weighed in this debate and scored some significant points. • Wieser, on the other hand, chose not to join in. • Wieser thought that the best method would tend to work itself out as economists got on with the doing of economics.

Conclusion • I think that, perhaps, Wieser’s stance is also my stance. • I have attempted to lay out Austrian methodology as I see it. • However, the bottom line is that most economists do not care about it. • So even if you win every debating point on methodology you encounter, I very much doubt that you will win many converts to Austrian Economics. • But then again, maybe you are the person to change the world.

Methodology By Paul F. Cwik, Ph. D.PCwik@moc.edu

Methodology for Introduction to Austrian Economics