Mises Wire

highly-complex models to a simple display of historical data. It is generally held that, through establishing correlations, one can organize historical data into a useful body of information, which, in turn, could serve as the basis for the assessment of the state of the present and future economy.

Things are, however, not as straightforward as they seem to be. For instance, if it was observed that declines in the unemployment rate are associated with a general rise in the prices of goods and services. Should we then conclude that declines in unemployment are a major trigger of price inflation?

To confuse the issue further, it could also be observed that price inflation is well-correlated with changes in money supply. Also, it was observed that changes in wages display a very high correlation with price inflation. So, what are we to make out of all this? On this, Milton Friedman wrote,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.

By popular thinking, so long as the theory/model “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the theory/model breaks down, we look for a new theory/model. The tentative nature of theories implies that our knowledge of the real world is elusive. Since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a model are. In fact, anything goes, as long as the model can yield accurate predictions.

For instance, an economist forms a view that consumer spending on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in the assessments of the future direction of consumer spending. If the model fails to produce accurate forecasts, it is either replaced or modified by adding some other explanatory variables.

Predictive Capability as Questionable

The popular view that sets predictive capability as the criterion for accepting a model is questionable. For instance, a theory that is employed to build a rocket stipulates certain conditions that must prevail for its successful launch. One of the conditions is good weather. Would we then judge the quality of a rocket propulsion theory on the basis of whether it can accurately predict the date of the launch of the rocket? The prediction that the launch will take place on a particular date in the future will only be realized if all the stipulated conditions hold. For instance, on the planned day of the launch it may be raining. The quality of the theory, however, is not tainted by an inability to make an accurate prediction of the date of the launch.

The same logic also applies in economics. Thus, we can say confidently that, all other things being equal, an increase in the demand for bread will cause its price to increase. This conclusion is true, and not tentative. However, will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory because it cannot predict the future price of bread?

Savings and Economic Growth

Now, economics is not about GDP, CPI, or other economic indicators as such, but about individuals’ purposeful activities and choices. Individuals operate within a framework of means and ends; they are using various means to secure ends. Purposeful action implies that individuals assess or evaluate various means at their disposal against ends.

In order to accomplish goals, individuals must act in space and time, employing scarce goods. These economic goods, however, are often not readily available—they have to be produced. Without tools at his disposal, the individual can only secure very few goods from nature (e.g., naturally-growing fruit). What enables greater production beyond just land and labor is the development of capital. However, this requires devotion of time and saving. Savings sustain individuals that are employed in the various stages of production. Similarly, in a modern economy, the extent of private saving and social time preference set the limit on the projects that can be implemented.

The enhancement of infrastructure is what facilitates economic growth. The enhancement of the structure or production or capital goods, in turn, can only take place as a result of prior production and saving. Hence, anything that weakens private saving undermines the prospects for economic growth.

Monetary Expansion and Savings

When money is generated out of “thin air” via inflation and artificial credit expansion, it undermines voluntary saving. The newly-generated money and credit sprang into existence out of “thin air” so to speak. The holder of the newly-inflated money can use it to withdraw goods from the economy, warping the structure of production.

One could infer from this that when money is inflated it diverts savings away from wealth-producers who have contributed to the structure of production. Consequently, all other things being equal, wealth-producers are likely to discover that the purchasing power of their money has fallen.

As the pace of inflation intensifies, this puts more upward pressure on time preferences and downward pressure on private savings. This distorts the price and capital structure. Consequently, the flow of production changes to one not demanded by consumers on the free market. This undermines genuine economic growth, devalues the money, unevenly increases prices, and leads to boom-bust cycles.

Expansionary monetary and fiscal policies, which aim at growing the economy, are, in fact, achieving the exact opposite—policies that create artificial growth at the expense of real growth. As long as private saving stays positive, it is possible to continue to sustain productive and non-productive activities to some extent. This helps generate the illusion that expansionary fiscal and monetary policies grow the economy. Trouble, however, erupts, when—on account of expansionary monetary and fiscal policies—a structure of production other than one that would have emerged on a free market.

Once the economy falls into a recession, any government or central bank attempts to revive the economy will fail. Not only will these attempts fail to revive the economy, they will further inhibit it, thereby prolonging the economic slump. This exposes the erroneous nature of the commonly-accepted view that expansionary monetary and fiscal policies can genuinely grow an economy.

The only reason why it appears that these policies “work” is because genuine production, saving, and capital investment often accompany them. Additionally, capital consumption can temporarily feel like new wealth while they actually are undermining growth. By assessing the intensity of the fiscal and monetary policies, which are the key factors that undermine saving, one can ascertain qualitatively the growth of the economy. Hence, rather than focusing on many economic indicators, it is much better to examining the state of saving and capital investment.

Conclusion

Contrary to much popular thinking, an increase in an economic indicator such as GDP does not imply improved economic health. Without an increase in voluntary saving, production, and capital investment, no lasting economic growth can take place. Economists and various other financial experts who derive their knowledge of the state of the economy solely from statistical correlations of the various historical pieces of data run the risk of misleading themselves and their audiences.

Image Source: Adobe Stock

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.