Some ramblings on Milton Friedman, praxeology, the Austrian School and George Soros

Nice of you to excuse what might have been just a poor choice of words. After all, 'not descriptively realistic', does mean 'descriptively unrealistic'!
 
Daal said:
The other day I was thinking about Milton Friedman's old critiscism of praxeology:

"So far as von Mises is concerned, I refer to his methodological doctrine of praxeology. That's a fancy word and it may seem highly irrelevant to my topic, but it isn't at all. Because his fundamental idea was that we knew things about "human action" (the title of his famous book) because we are human beings. As a result, he argued, we have absolutely certain knowledge of motivations of human action and he maintained that we can derive substantive conclusions from that basic knowledge.

Facts, statistical or other evidence cannot, he argued, be used to test those conclusions, but only to illustrate a theory. They cannot be used to contradict a theory, because we are not generalizing from observed evidence, but from innate knowledge of human motives and behavior. That philosophy converts an asserted body of substantive conclusions into a religion. They do not constitute a set of scientific propositions that you can argue about in terms of empirical evidence.

Suppose two people who share von Mises' praxeological view come to contradictory conclusions about anything. How can they reconcile their difference? The only way they can do so is by a purely logical argument. One has to say to the other, "You made a mistake in reasoning." And the other has to say, "No you made a mistake in reasoning." Suppose neither believes he has made a mistake in reasoning. There's only one thing left to do: fight. Karl Popper — another Austrian like Mises and Hayek — takes a different approach. If we disagree, we can say to one another, "You tell me what fact, if they were observed, you would regard as sufficient to contradict your view. And vice versa. Then we can go out and see which, if either, conclusion the evidence contradicts. The virtue of this modern scientific approach, as proposed by Popper, is that it provides way in which, at least in principle, we can resolve disagreements without a conflict."

I think Friedman was mistaken on this, but not because of the reasons the Austrians think, they are probably wrong too. The issue is that its extremely difficult to apply the 'scientific method' to markets, economies, etc. Those are 'extremistan' domains, the 'evidence' is not much evidence of anything. Most people fall in love with statistics, studies, numbers, etc. It seems to be a form on anchoring and overconfidence biases.

But if you rank the level of empirical proof all the way from double blind trials with large sample sizes, to observational studies without controls, regressions, etc. You will quickly see that what constitutes 'evidence' in financial markets, its at the very bottom in terms of quality in the empirical world. Furthermore, you have the issue of sample sizes. As a simple example, just to know with a high degree of confidence the standard deviation of stock prices, you need 10^13 samples in the data set (thats 10 trillion. That acc to Taleb). A lot of studies are shredded to pieces as you add more data (particularly if there arent enough outliers in the original sample) or if you test it in more countries.

This is not to say that one cant look at numbers to form beliefs, you can, my point is the degree of belief (the confidence) that you attach to the idea that you understand the real world should not be high if its coming from those studies, statistics and indicators. Simply because they are not empirical enough to form high conviction beliefs, they help a little but only a little. That is the mistake of the monetarists, they attach too much confidence to these numbers and studies, when they dont deserve as much.
The mistake of the Austrians is similar, but their issue is that they simply attach too much confidence to their own logic, even if it contradicts the data. A flexible mind would at least slow down when faced with contradictionary data.
This is not to say that its always a mistake to do that but the problem is that the world is complex and full of surprises, to have an understanding and a domagtic view of the world based on such logic, its very likely to lead to problems due overconfidence bias or just flat out being wrong.

The solution to this issue is what great market practioneers like George Soros have figured out a long-time ago. He says that markets arent like hard sciences like physics but more like Alchemy (in other words, there is an art component to markets). You cant certain about things and be dogmatic about it, but rather to be constantly testing hypothesis and have the markets reject them or accept them. Mental flexibility seems to be a key part of that approach. That mental flexibility is very much connected to the idea of uncertainty about what is true/right, which is pretty much the opposite of how dogmatic autrians behave when they think they got it all figured out or when monetarists do the same based on the `evidence`.

The issue is that these Soros mindsets installs on the trader/investor a sense of not knowing what is going on which doesnt help when great trades are found and a big position might be appropriate. How to have a big position when you are not truly certain you are correct? This only increases my level of admiration to the achievements of Soros (and Druck after him), he was able to retain his highly flexible mindset but at the same time, to have the courage to put big positions despite all of that. The results was a 30% CAGR for quite some time, it was truly a remarkable achievement
More...

This is my view of Milton Friedman and what he was trying to achieve in economics.

http://morganisteconomics.blogspot.co.uk/2011/02/milton-freidmans-greatest-contribution.html
 
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