An increasing number of economists have discovered that orthodox economic theory cannot function as a theoretical basis for their empirical research. Now they must choose: improve their theory or throw the theory away. Many researchers fall back on empiricist views – which is very bad news. They should read Carl Menger!
Menger on exact laws versus empirical laws
In his Investigations into the Method of the Social Sciences With Special Reference to Economics (1883) Menger takes position in the Methodenstreit between the deductivism and inductivism. Menger advocated the deductivist approach and saw the formulation of exact laws as a necessary element in the development of reliable knowledge. According to him exact theory is based on a few axioms. There are universal categories, such as ‘economic’ and ‘rational’, and exact laws are describing the interrelationship between the essences of these categories or concepts; essences which are formulated in definitions of a particular object. So, exact laws are propositions expressing universal connections among essences. Our reality as we experience it permanently, is about properties and can change continuously. When an object is defined we can observe its properties. Without systems of definiitons empirical researchers are blind. Only under a number of conditions the exact phenomena approach the real phenomena. Menger formulated four important conditions, which functions as axioms in exact economic theory. (1) People tend to be egoistic, selfish or self-interested; (2) people tend to be rational; (3) people have full, complete or perfect knowledge of the situation with which they are confronted; and (4) people are not influenced by error, ignorance and external compulsion (i.e. they are free and not coerced by government). With respect to the phenomenon ‘price’ we can say that the exact theory analyses economic prices, while reality shows real prices. The difference between the two is determined by the degree of realism of the axioms. To use exact theory in our attempt to understand daily reality we must conceive an abstract world that holds to the four conditions just mentioned. Logical implications, which are derived from the axioms, give us the exact propositions.
Empirical testing of exact theory shows that the set of axioms is not realistic most of the time. To clarify this point we make a distinction between two types of abstraction. Abstraction in general means that particular elements are left out of the analysis, so as to have a picture of reality. In some cases scientists abstract from elements, which are considered relatively irrelevant for the problem under scrutiny. In other cases also important elements are left out of the analysis. The second one is named ‘isolated abstraction’. The scientist tries to isolate one aspect of the behaviour of the subject under scrutiny, and analyses how it works if this aspect would be the only one relevant. In a later stage other aspects must be isolated and studied. When empirical research is an important aim all relevant aspects should be integrated into a whole of aspect-analyses. Menger does not discuss various other aspects and sticks to the summing up of a few other ‘fundamental motives’, such as moral sentiments, altruism and justice.
Menger rejects the idea of empirical laws, as defended by the German Historical School. In practice we might find empirical relationships, which are only stable in particular locations for a short period. Famous is the Taylor rule, saying that the real interest rate as set by the American central bank is related to the output gap and the gap between the actual rate and the target rate of inflation. Taylor found this relationship, and considered it as an important stabiliser of the American economy. When de central bank began to deviate from the empirical relationship Taylor was very angry with his friend Greenspan, the chairman of the central bank! Other examples of empirical relationships are Okun’s law and the Phillips curve. The last one has become an icon of modern macroeconomics. But in its original version Phillips decided to leave a large number of observations out of his analysis already: they did not fit his ‘stable’ relationship. A recent empiricist product is the study by Reinhart and Rogoff, who compared many financial crises in the post-war period. On the basis of many facts they calculate averages (Reinhart, Rogoff, 2009). Fact in themselves are silent, and so is their study. In other work they draw far-reaching political conclusions about the level of government debt, for instance. It goes without saying that for them numbers are very telling – but their empiricist attitude makes it impossible for them to unveil their axioms and beliefs.
Empiricism is a very attractive methodology for scientists: no beliefs and other subjective elements in the analysis; just facts. We can interpret empiricism as a type of trauma that results from horrible events, created by totalitarian institutions.These regimes – communist, fascist, catholic, muslim – assume that they have perfect knowledge, while other people are misled. Believers are not willing to participate in reasonable debates, and therefore they are not scientific. The Wiener Kreis defended the position that only facts and logic are acceptable ingredients of science. Popper ( and definitely also Menger) disagreed and defended the proposition that facts without any theoretical basis do not exist. Empirical facts are constructions, and we cannot construct inflation and unemployment figures, for instance, if we don’t have defined the (theoretical) concepts inflation and unemployment. Different approaches lead to different empirical facts. According to the CBS Dutch unemployment among young allochtone people was about 20% a couple of years ago. According to the SCPB the figure about 40%. They battled on the front pages of famous Dutch newspapers. Of course the answer is that the two organisations used a different approach: the CBS used a typical neoclassical economic definition and the SCPB used a more sociologically orientated definition.
Like Walras and Pareto Menger saw the development of exact economic laws as the main task of economics. They were also active in the development of other types of approaches. Menger was an Austrian who was interested in the historical development of institutions, such as the increasing acceptance of particular forms of money. Unfortunately sociologists and psychologists did not apply the method of isolated abstraction. Therefore economists should make social and psychic analyses of the respective aspect-systems. Only then we might reach the stage of having a realistic theoretical foundation, which makes also empirical research possible.
(1) Menger, C. (1883), Investigations into the Method of the Social Sciences With Special Reference to Economics.
(2) Reinhart, C.M., K.S. Rohoff (2009), The Aftermath of Financial Crises, NBER, working paper 14656.
(3) Phillips, A.W. (1958), The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.
(4) Taylor, J. (1993), Discretion versus Policy Rules in Practice, Carnegie-Rochester Conference Series on Public Policy, pp.195-227.