Modern economists do a lot of number-crunching, but even the numbers aren’t enough to answer some basic questions, writes
ECONOMIC theorems “are derived not from the observation of facts, but through deduction”. Early 20th-century economist Ludwig Mises’ declaration might seem odd today, when economists without data to back up their arguments aren’t taken seriously. But “armchair” economics used to be the norm. Keynes’ famous and influential 1936 book The General Theory of Employment, Interest and Money was used to justify government intervention in the economy, but was highly abstract, teeming with jargon that barely touched on the real world. Adam Smith’s seminal 1776 work The Wealth of Nations – the closest thing economics has to a foundation document – used history and examples to explain how free markets underpin prosperity, but his reasoning was largely deductive.
In fairness, the sort of data series that economists now take for granted, such as GDP, the distribution of incomes and wealth, and unemployment, didn’t exist then – not to mention the computing power. But before World War II, economists, notably those working at the University of Chicago, began insisting that economic theory was useless without empirical backing. By the 1960s Milton Friedman, who embodied the “Chicago school” of economics more than any other, had used data to settle a raging debate over the causes of the Great Depression. By painstaking examination of monetary and fiscal statistics from the 19th century onwards, Friedman showed that the US Federal Reserve – not the “free market” or a lack of government stimulus – was responsible. Rather than bolster the US money supply, as Fed chairman Ben Bernanke did in 2008, the institution in the 1930s let the US money supply shrink by a third, precipitating a disastrous fall in prices.
Chicago economists, armed with a growing battery of social and financial data, extended the scope of economics to crime, marriage, welfare and the bureaucracy, to show that people’s primary motivation was self-interest, whatever they might like to believe.
Chicago economists weren’t against theory, but it had to earn its keep, with Friedman declaring that the hallmark of a successful theory was its ability to predict actual outcomes. Fittingly, his own conviction that holding money supply growth constant would guarantee stable price inflation was undermined by the reality of the 1980s.
While using advanced statistics to test economic theory is now standard, some of the thorniest questions remain unanswered. For a start, data can be of poor quality. Up until its 1985 edition, Paul Samuelson’s best-selling textbook Economics was still touting the economic superiority of the Soviet Union, which collapsed four years later.
The inability to undertake controlled experiments, holding other factors constant, bedevils economic analysis. Do degrees boost graduates’ incomes, or were they already more able? Would growth have been slower without debt-financed stimulus? The data cannot answer that definitively.
And the world’s top economists disagree about the optimal rate of income tax, with estimates going all the way up to 90 per cent. Despite strong evidence that higher top rates promote tax avoidance and evasion, whether they actually deter individual effort is much harder to pin down.