Have the Laws of Economics Changed?

The correlation between economic freedom and economic prosperity is well-established and robust. Economics explains why this relationship exists and also the causal direction — economic freedom is the cause and prosperity the effect.

I am by nature in favor of freedom of all flavors, not just economic freedom. I value freedom as an ultimate good, although it fortunately happens to be an instrumental good too. Even if material prosperity did not follow from economic freedom — meaning that it was not instrumental in creating wealth — I would still value economic freedom for itself. Philosophically I am not a utilitarian.

These musings are provoked by a comment to the piece on Economic Freedom and Well-being last week. Here’s the comment:

The question “Have the laws of economics changed?” is predicated on the assumption that there indeed are “laws of economics” like the laws of the natural (or hard) sciences like physics and chemistry. Yes there are laws of economics but they are unlike the laws of the  sciences.

The law of gravitation applies to every material object regardless of how one feels about the outcome. It is not a matter of opinion or fashion that two gravitating masses mutually attract each other with a particular force; it’s what it is and hold without exceptions.

But the laws of economics are statistical in nature. They hold on the average but not in every instance. The thing is that, unlike physical laws which deal with inanimate objects that lack volition, economics deals with people who have the capacity to choose to act in different ways. People act strategically. They can choose differently than what averages predict.

Strategic behavior is typical of sentient beings, not of rocks. If you kick a rock, it just gets kicked. If you kick a human being (or even a dog), you get a reaction that isn’t simply dictated by the mechanical Newtonian laws of action and reaction.

Occasionally you may encounter instances where the laws of economics have apparently been violated but on the aggregate the laws operate pretty much as advertised. For instance, consistent with the law of demand you will find that people buy less of something when the price goes up, and vice versa. The existence of Veblen goods[1] does not invalidate the law of demand that holds with near-universal generality.

Economics has scientific content. Meaning it investigates some aspect of the world scientifically: hypothesis, observation, theorizing, modelling, selection among hypotheses, etc. But it is not a predictive science. It’s an explanatory science. Economics explains why something happened when it did; it cannot tell with certainty what will happen when.

For example, economics explains the wealth of nations. Why is Singapore rich and Somalia poor; how did Singapore become rich although it was quite poor a few decades ago; how did Venezuela become poor even though it has immense oil wealth; why did the industrial revolution happen in England and not in China; etc.

Explanation is post hoc. After the event. Good explanations have to be logically consistent and conform to the reality of the world. Explanations are ultimately arguments, and therefore good arguments have to be both valid and sound. Validity of an argument follows from its logical consistency, while soundness depends on the premises of the argument being true.

While economics cannot make precise predictions about a future state of the world, it is capable of making trend predictions. It’s like in medicine. If you smoke, you are more likely than a non-smoker to suffer lung disease. That holds on the average even though non-smokers do suffer lung disease because of factors others than smoking.

So there are laws of economics. Instances of apparent violations of those laws does not mean that the laws change arbitrarily or are occasionally suspended. It  just means that the explanation for why what happened has to deviate from the more common explanation.

The case of China’s fantastically fabulous rise from extreme poverty to an economic power threatening to rival the United States does challenge economic theory. However basic economics principles are sufficient to explain China’s rise, or for that matter India’s stagnation, or Venezuela’s rapid descent into poverty.

Prosperity and economic freedom are causally linked. But prosperity is not mono-causal. Many factors enter into the outcome, none of which are absolutely necessary nor sufficient. What is definitely true is that a country with economic freedom is better off than without economic freedom. China without economic freedom is worse off than a China with economic freedom, all other things being equal. 

That last italicized phrase makes all the difference when we examine something using the principles of economics. To isolate the influence of one factor — say literacy — on prosperity, we have to vary that factor while maintaining all other factors at constant levels.

In the following piece, I will take a shot at explaining China’s rise even though China does worse than India, Namibia or Nepal in economic freedom ranking.

NOTES:

[1] Veblen goods are types of luxury goods for which the quantity demanded increases as the price increases, an apparent contradiction of the law of demand, resulting in an upward-sloping demand curve. A higher price may make a product desirable as a status symbol in the practices of conspicuous consumption and conspicuous leisure. A product may be a Veblen good because it is a positional good, something few others can own. [Wiki.}