In 1953, Milton Friedman set out to establish “The Methodology of Positive Economics” to improve economics’ contribution to determining policy. He believed that “differences about economic policy among disinterested citizens derive predominant from different predictions about the economic consequences of taking action...rather than from fundamental differences in basic values. (p. 2-3)” While the goal was worthy of the task, it becomes clear quite quickly that Friedman’s normative views will shape the discussion.
Friedman begins by explaining that “The ultimate goal of a positive science is the development of theory” or “hypothesis” that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed. (p. 3-4)” While few would probably disagree with that statement, a divergence of opinion tends to arise when assumptions upon which a hypothesis rests are unrealistic. However, once one understands the “canons of formal logic (p. 4)” it becomes readily apparent that a hypothesis cannot be rejected solely on these grounds. A basic proposition of formal logic is that x implicates y (x → y) is always true, unless x is true and y is false. Therefore a hypothesis is valid if the predicted outcome (y) occurs, regardless of whether the assumptions (x) are realistic. Although Friedman was only restating the principles of formal logic, arguments of this kind remain prevalent today, hence the importance of his point cannot be understated.
After dispelling the notion that a theory can be rejected based solely on its unrealistic assumptions, Friedman ventures on to the far more difficult task of applying positive economics to policy determination. At this juncture the discussion takes a distinctly normative turn, which Friedman acknowledges but downplays at the same time. The troubles with making this application are primarily three-fold:
1) How does one determine if a theory is valid?
2) How does one choose among hypotheses that are consistent with available evidence?
3) How does one decide the circumstances for a which a theory holds?
Regarding question one, Friedman points out the inherent difficulty (near impossibility) of conducting “controlled experiments” in the social sciences “foster[ed] a retreat into pretty formal or tautological analysis.9 (p. 6)” This path is clearly not suitable if economic theory “is to be able to predict and not merely describe the consequences of action. (p.7)” Empirical evidence seemingly offers the greatest potential for validating theories, but leads to the normative question of “whether [a theory] yields sufficiently accurate predictions. (p. 9)”
Moving beyond questions of validity, Friedman accepts that “The choice among alternative hypotheses equally consistent with the available evidence must to some extent be arbitrary, (p. 5)” but believes “there is general agreement that relevant considerations are suggested by the criteria “simplicity” and “fruitfulness”. (p. 5)” Friedman also mentions “logical completeness and consistency” as criteria which “are relevant but play a subsidiary role. (p. 5)” Establishing the relative weights of these criteria, let alone the relative value of different hypotheses on each scale, clearly extends into normative economics. On the whole I find Friedman’s support for his normative views unconvincing and suggest reordering the criteria as follows: fruitfulness, consistency, logical completeness, and simplicity.
Assuming agreement on a specific, valid hypothesis, one must still decide how “to specify the circumstances under which the formula works. (p. 11)” Friedman argues that “the assumptions [cannot] be used to determine the circumstances for which a theory holds. (p. 11)” Instead, the validity of the hypothesis tells us whether the theory holds for given circumstances. Unfortunately this statement is no more than a tautology and offers little guidance for applying policy to different circumstances in advance of known outcomes. Here we find the importance of a hypothesis’ logical completeness and consistency. Without knowing in advance if, and to what degree, a hypothesis will prove correct, the assumptions (regardless of how unrealistic) become a necessary guide to determining applicable circumstances.
Friedman sets out on the difficult task of developing a positive economics with normative implications. While his efforts to prove that a hypothesis must not be judged solely by the realistic nature of its assumptions were valiant, this strength of his paper has been largely overlooked. Instead, Friedman’s normative views regarding determination of a theory’s validity, choosing among competing valid hypotheses and application to specific circumstances have indoctrinated economists with a means to defend orthodox, mainstream economics from all criticism.
These departures from the “positive”, though not explicitly or (maybe) even implicitly intended by Friedman, have led to the frequent practice of three pitfalls in straight thinking:
1) Fallacies of composition - Ex. Households face a budget constraint based on income and ability to borrow, therefore governments must face similar constraints.
2) Fallacies of analogy - Ex. Greece’s sovereign debt rates are high because of its large public debt-to-GDP and Japan has higher public debt-to-GDP, therefore Japan’s sovereign debt rates should be soaring.
3) Post hoc ergo procter hoc (i.e. "after this, therefore because of this") - Ex. Lehman Brothers went bankrupt right before the financial crisis happened, therefore the failure of Lehman Brothers caused the financial crisis.
The failure of mainstream economics to predict the housing bubble, financial crisis, recession, and weak recovery, has not materially weakened the acceptance of previously held theories. This should not be surprising given Friedman’s claim that “the continued use and acceptance of [a hypothesis] over a long period, and the failure of any coherent, self-consistent alternative to be developed and be widely accepted, is strong indirect testimony to its worth. (p. 14)” Contrary to this view, advances in modeling network systems implies that suboptimal outcomes can actually be self-sustaining.
“The Methodology of Positive Economics” is ultimately both a positive and normative method for discerning real implications of economic hypotheses, although the line has become blurred over time. If economics is to regain its grandeur, it must recognize the strict limits of positive economics before readdressing the normative decisions posed by Friedman. In this manner, economics may come to study and accept a much broader range of hypotheses that are not only more fruitful, but also more logically complete and consistent.
Update - Credit should be given to Ernest Nagel’s paper, “Assumptions in Economic Theory”, for inspiring a number of my thoughts in this post.