Proper methodology is often debated in economics. Inevitably, one side points out that the other side has made some very embarrassing predictions. Pro-market folks love to reference WWII era Keynesians who thought that the United States would go back into depression after the government stopped spending vast amounts of money on war goods. As it turns out, the economy boomed after the war. Pro-government folks respond by pointing out that while Austrians may have identified this recession, they have predicted many other bubbles, recessions, and downturns that failed to transpire. How relevant are these comments?
Economic theory must be derived from axiomatic knowledge of human action, the ultimate causal factor. From here, economists must use deductive reasoning to establish economic laws, like marginal utility, supply, demand, etc. This is the foundation of economic theory.
Economists must also be able to apply these theories to the real world; otherwise they’d be useless. Essentially, can the historical (empirical) facts square with the theory developed? If not, economists have to reassess their assumptions and reasoning, as well as the historical facts.
Positivism (popularized in economics by Milton Friedman) is a rejection of this methodology. Essentially, it inverts the order of theory and history. Laws must be derived from historical data, as in the natural sciences. The problem with applying positivism to economics, as pointed out by Mises in The Ultimate Foundations of Economics, is that it fails to account for human finality, or choice of ends. Humans choose their ends, which influences their action. Do rocks or galaxies choose what they do? Thus, the proper method for developing economic law must account for human volition, which positivism cannot.
But where does forecasting enter? It is true economists use their theories to make predictions. If they are wrong, does that mean their theory is also wrong? Not necessarily. They could have been acting on bad information, or they might have failed to account for the proper causal factors. Just because economists have bad predictions doesn’t necessarily mean their theory is bankrupt. If that were the case, than all serious economic theories would be wrong.
The proper way to discredit a theory is on logical grounds. Are the assumptions correct? Is the logical chain connecting the assumptions and the results correct? If a theory does not match reality, than the theory could very well be wrong and this occurrence demands investigation.
The ultimate reality that all economic theory must conform to is human action. If any theory’s assumptions marginalize human’s choice of ends, uniqueness, etc, it is more unrealistic than all the various theories that have not passed quantitative muster.
“The embarrassing fact that the forecasts of would-be economic sooth-sayers have always faced an abysmal record, especially the ones that pretend to quantitative precision, is met in mainstream economics by the determination to fine-tune the model once more and try again. It is above all Ludwig von Mises who recognizes the freedom, of mind and of choice, at the irreducible heart of the human condition, and who realizes therefore that the scientific urge to determinism and complete predictability is a search for the impossible – and is therefore profoundly unscientific.”
–Murray Rothbard, in the preface to Theory and History by Ludwig Von Mises.