Financial markets involve various individuals engaged in the buying and selling of financial assets. Most of the time, the actions of the market participants are driven by popular ideas. If the market participants were to follow a theory that corresponds to reality, then the market will reflect this. Conversely, if the decisions taken by the market participants are based on assumptions that are detached from reality, then the direction of the market is likely to follow.

According to Milton Friedman, 

The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.

The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.

Hence, according to Friedman, since it is not possible to establish “how things really work,” then anything goes, as long as the theory could generate accurate forecasts. This means that what matters is not trying to understand the nature of things (i.e., to ascertain the economic fundamentals) but to have a theory that generates accurate predictions. But is forecasting capability a valid criterion for accepting a theory?

For instance, all other things being equal, an increase in the demand for bread will increase its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot forecast the future price of bread?

The criteria for selecting a theory should not be its predictive ability but whether the theory is logically valid and corresponds to reality. In Philosophical Origins of Austrian Economics, David Gordon writes that Bohm-Bawerk maintained that concepts employed in economics........

© Eurasia Review