Economics Theory Versus Empiricism

Economic theory is informative, but it is similar to some psychological theories: it should be empirically moderated with very skilled critical thinking skills, uncertainty, and skepticism.

I first was quite drawn to socialist economic theory in the early 1990s, and was quite sure of myself. I thought I understood economics. Rich people are a bit more ruthless than my family, and their ancestors must have cheated and subjugated more people than my family did. It was a complete economic theory that explained everything I observed in the world. I was sure. Decades later, after being surprised in many election cycles, after living in the UK and the US, after slowly learning the economic history of numerous nations, after listening to all sides, I am now an empirical skeptic on the topic.

After all I have experienced, combined with my 17 year focus on how to distinguish science and pseudoscience in psychology (a similarly complex field to economics), I now have to admit I was wrong about socialist theory. It simply led to predictions that were poor: if I were to simply search for disconfirming evidence, the evidence was abundant. Even for the working classes, who still drive my affections as much as they did when I was a socialist, socialist policies have immiserated them relative to free market countries. The evidence is messy, but it accumulates: North Korea relative to South, East Germany relative to West, USSR relative to USA, 1960s UK relative to 1960s Germany or USA, 1990s China relative to 1990s Hong Kong, 2020s UK relative to 2020s Australia, 1980s Eastern Europe vs Western Europe. In all of these comparisons, the opportunities and freedoms of those in the less socialist state appears just better. I just didn’t know all of this decades ago. I still am unsure, and I’m proud to be open minded and skeptical.

So if you are guessing that I am now a classical liberal when it comes to economics, you would be almost correct. To be precise, I am a cautious classical liberal—which means I am interested to see if classical liberal policies work in practice. Do I support less government spending? If it raises thriving in a population, then yes. Do I support everything Thatcher did in the name of privatization? Probably only those things that had a long term benefit for working people in the UK. Similarly with Reagan: it depends on the policy, and it depends on how much I have time to examine the evidence. Do I support all the policies of Javier Melei in Argentina? I would have to spend a few years examining the effects and the policies, but the severity of his approach concerns me. I search for disconfirming arguments: I think about a government worker who is working hard, who is doing a lot of good, who might be holding together the social fabric of a society, and who might be fired in the sweeping changes that extreme minarchists might bring. That actually might be a loss for a nation. I’m open to the data as it comes in.

But in my years of trying to learn about economics, I have noticed I am much better at making predictions now (before seeing the data), compared to when I was a socialist. As a socialist, I was consistently surprised (and annoyed) at how my predictions didn’t pan out. But just recently, using a hybrid of Austrian and Chicago schools of classical liberalism, I have been much better able to anticipate inflation and interest rates years ahead of time in an approximate way. My theories are still not great, but just a bit more predictive. I noticed this predictive power while talking to a forensic psychologist in Australia. I heard that the working person can earn more in his field in Australia, compared to the UK, and I heard a few other differences in a long conversation. A prediction came to my mind: Australia sounds like the USA when it comes to social mobility for skilled workers: I would guess Australia has a lower tax percentage than the UK and probably a tiny bit higher than the USA. I turned to my new friend and said: “I bet the tax per GDP is less than the UK, but maybe a bit higher than the USA.” We looked it up on my phone, and on the source I used at the time it was 29% tax per GDP in Australia (28% in USA). Perhaps a half an hour later, I had now heard how New Zealand forensic psychologists have been emigrating to Australia for jobs and better pay. I made another prediction out loud to my colleague: “I bet New Zealand’s has a tax per GDP is higher than Australia’s, perhaps above 32% of GDP).” We looked it up on my phone together, and it came up as 34% tax of GDP. “Isn’t that amazing?” I said to my new friend. These very rough predictions are hardly scientific, and vary from source to sourece, but relative to my former abysmal predictive power, classical liberal economics is better at prediction than my former socialist economic lens.

So if I am a “cautious” or skeptical classical liberal, what do I propose? It depends. If the taxes in a given nation are more than 30% of GDP, I would suggest lowering spending and taxes. If the taxes in a given nation are less than 20% of GDP I would support increasing taxing and spending if it helps raise opportunities, provide a safety net for the disabled, and social mobility in that nation. Why? It is purely from observations of wages, thriving, and social mobility opportunities in some countries (e.g., Australia, USA) compared to other countries with lower wages and less opportunities for working people to progress (e.g., New Zealand, UK).

But I do want to return to the premise of this article: despite some improvements I do not have an economics theory I believe in ideologically, even after years of thought and searching. I do not think that theories are infallible at the scale of human behavior at massive scale. Similar to psychology, you have to use roughly explanatory and testable theories to guide research and policy, but the grounding principle should always be data and empiricism. What works best in practice, what leads to the greatest opportunities, what leads to wealth creation, what leads to excited and free populations of people, and what leads to working people being able to become rich over decades if they are disciplined.

As it stands today, what seems to work is a mix of small-to-medium government, high-trust cultural norms, freedom to trade, periods of no wars, taxes around the mid to high 20s percent of GDP, and a whole range of other cultural conditions and norms seems to predict thriving in several continents.

In terms of recommendations for further reading, I encourage readers to consider reading work by Thomas Sowell. His country-by-country comparisons, and his work on how trust builds opportunity for wealth, are well argued and pass my scrutiny for being well evidenced with a similar critical thinking skills that I use in psychology. Here below is an audiobook of Sowell’s Economic Facts and Fallacies. I do not agree with everything Sowell has said, but he does seem to use an empirical approach.

So if you and I should not be too sure on economic theories, what about economics professors at universities? They are fallible too, but it should give us former socialists pause to know that most economics professors are much less left wing than almost all other professors in other departments in the university system. It should also give those on the other side of the extreme, such as anarcho-capitalists, pause as well, to realize that most economics professors are not all in agreement with that either. Like psychology, it is a highly complex and messy empirical science.

Postcript edit: After writing this essay and then searching for % tax per GDP percentages from other sources than I was using when I was, I find other ways of calculating or estimating it lead to different figures from variaous websites. I did however notice the same pattern as discussed above, even when it is calculated differently on different sites. (e.g.: here or here).