Economic analysis relies on models. It has no choice but to rely on models for the same reason that useful maps ignore a lot of information that is valuable to someone — there’s just too much data in the real world to analyze in one sitting.
Models start with assumptions and then investigate whether the implications of those assumptions contradict the facts. It is generally acknowledged that the value of a model is open to question when the facts contradict the implications of the model. (However, it is also common to see a spirited defense of models that are not consistent with the facts.) When the model is consistent with the facts, the modeller has a winner. The modeller does not, however, have the winner. The modeller has just presented us with one of many stories that can explain the facts.
Economics faces the same problems as the field of epidemiology (amongst others): the model underlying the data analysis assumes causality and statistical methods can be used to show that the assumption of causality is not contradicted by the data. In fields where controlled studies are impossible there is, however, little hope that statistics can be used to positively confirm that the assumption of causality is a good one.
Thus, economists are frequently found making arguments along the lines of: Given my assumptions I reach these conclusions. Since these conclusions are consistent with what we know about the world, my assumptions are good.
To which the logical response is: Maybe you’re right and maybe you’re wrong; maybe your assumptions are good and maybe they’re bad. You still haven’t justified to people who have doubts about your model that there is any reason to believe in it.
In short, until economists recognize that they need to defend the assumptions underlying their models at the level of pure theory, they will continue to be accused of circular logic. In my view the problem with economics today is that only a small subset of economists see the need to defend the value of their arguments on a theoretical level.
Despite my view that most modern economists have yet to come to terms with the basic principles of logic, I actually think that Ted Gayer‘s defense of “market based mechanisms” is correct. The reason that I think Gayer is correct is because I find Hayek‘s explanation of why market based mechanisms are better convincing — that is, because somebody took the time to convince me at the level of verbal argument and pure theory that market prices are directional signals that are essential to the ability of a successful economy to function.
Too many economists seem to take the view that: Well, Hayek convinced me, so I feel free to take it as a given that Hayek is correct and expect my readers to do the same. They should not be surprised if a huge number of people who have never read Hayek find this approach arrogant and illogical. Any economist who is above using verbal argument to demonstrate why the pure theory underlying his or her approach is correct — even if this just means that the economist paraphrases Hayek — deserves to be accused of circular logic.
Synthetic Assets 