• February 4, 2023

How Economics Lost Itself in Data

William Allen, professor emeritus of economics at the University of California at Los Angeles, died on January 15 at the age of 96. Few noticed, but Allen’s death was significant. It was a generation change in business that is bad for economists and the public. Allen really believed in economics – something difficult to say about most economists these days.

Allen was among the last of a generation of economists to master their craft. Together with his friend and colleague Armen Alchian, he wrote an excellent economics textbook that conveys the power and potential of the economic mindset: Despite the complexity of markets, economists can put the way they work at the center by focusing on prices. This insight is so important that it gives a name to the economists’ core toolkit: price theory. No one can be an economist who is unfamiliar or uncomfortable with this toolkit.

However, there are not many economists left by this standard. Professional economists are to give up Price theory in droves. The new status quo has stirred up the field. The economy is increasingly less scientific and more vulnerable to political influence.

The absence of price theory in economic research today would have confused the great economists of the past. In contrast to the naysayers in the field, the golden age of price theory of the 20th century was never about “neoliberalism” or “market fundamentalism”. Instead, a simple but brilliant framework was applied to markets, uncovering the hidden ways in which market prices – the relationships between goods – enabled an extraordinary degree of economic coordination. It also showed why many (but not all) restrictions on price adjustments, such as B. Rental controls, resulted in costly and unproductive secondary effects. This was all part of a comprehensive explanatory project. While individual economists had their political preferences, the economic mindset was above politics.

For years the economy has become less theoretical and more empirical. Economists spend less time building and thinking through simple models and more time collecting and analyzing data. The “identification revolution” in business has paid off in the form of elite publications to find good data from quasi-experimental settings and to conduct advanced statistical analysis. Better empirical work should definitely be welcomed. But it came at a price: a whole cohort of economists with serious theoretical blind spots.

Data does not interpret itself. Contrary to the reputation of this new generation of economists, we cannot “just let the data speak for itself”. What and how you measure depends on theoretical judgments about how markets work. The way you understand concepts like competition, barriers to entry, and market power can completely change how you interpret identical data. Is an industry with a small number of high-income companies oligopolistic because of its concentration? Or is it competitive due to continued customer satisfaction? Price theory helps us understand these questions. Accessing the data without a solid theoretical foundation is an invitation to confusion.

The heights of the business profession are increasingly inhabited by people who despise price theory. Reliance on the economic mindset in solving problems is viewed as outdated and unscientific. The data jockeys think they are up to date, but they are just repeating old mistakes. In the late 19th and early 20th centuries, the economists of the German historical and old institutionalist schools thought they could do with history and statistics on their own without being limited by theory. In the end, they were so lost in detail that they could think of very little that lasted.

One common anti-pricing theory is that its practitioners are political ideologues disguised as scientists. The opposite is closer to the truth. The old school economy realized that there are compromises and limitations everywhere. There are no free lunches. Armed with price theory, economists opposed the politically appealing but economically unsound proposals from both the right and the left. Today’s economists, innocent of price theory, have no such armor.

The atheoretical approach of contemporary economists makes them particularly vulnerable to the technocratic claims of the center-left. If, contrary to the claims of price theory, there are no permanent economic laws, there is no reason to stop technocrats from tinkering. Many of these economists do not know that they have been politically compromised. They see it as “just the facts, ma’am” pragmatism. In reality, it’s an ideology that sneaks through the back door.

As an example, consider the debate about the 2017 corporate tax cut. It was about whether labor or capital would benefit from the cut. Price theory economists such as Greg Mankiw, Casey Mulligan and Steve Landsburg predicted great benefits for workers. Empirical pragmatists such as Gabriel Zucman, Emmanuel Saez, and Larry Summers found this prediction not only unscientific, but also dishonest.

Team price theory, it turned out, was right: workers saw huge wage increases after the corporate tax cut. As capital adapts over time in response to tax increases, the labor force remains the brunt of reducing productivity. But the opposite is also the case: taxes on capital will be lowered and labor will increase sharply. The long-term adaptability of capital is a classic result of price theory. Score one for the old school.

While the divergence between price theory and pragmatism is evident in political debates, politics is not the biggest problem here. What the government should or should not do is a value judgment. An economist could agree with Messrs. Mankiw, Mulligan, and Landsburg on the growth effects of corporate tax cuts, but could oppose it for reasons of deficit. However, the fact that the supposedly ideological and non-rigorous economists were ahead in this kerfuffle shows that price theory by scientific standards – understandability and predictability – still plays a role.

To fix the economy, economists must again insist on the primacy of price theory. The economic mindset is not optional. Nor is it an obstacle to social science. In fact, price theory is the only thing that social science enables. William Allen left us, but what is dead can never die: we still have his articles and books, as well as those of his friends and colleagues. Whatever the fads among economists, the enduring contribution of economics to human knowledge is and will be price theory.

Mr. Salter is an Associate Professor of Economics at Rawls College of Business at Texas Tech University and a Fellow at TTU’s Free Market Institute.

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