Financial markets are various individuals engaged in the buying and selling of financial assets. Most of the time, the actions of market participants are driven by popular ideas. If the decisions taken by the market participants are based on a theory which is detached from reality, then the direction of the market is likely to follow the theory. Conversely, if the market participants were to follow a theory that corresponds to reality, then the market is most likely going to reflect this.
The employment of theories that are based on unrealistic assumptions was inspired by the writings of economist Milton Friedman. According to Friedman, since it is not possible to establish “how things really work,” then anything goes, as long as the theory can generate accurate forecasts. This means that what matters is not trying to understand how things work (i.e., to understand the economic fundamentals) but to have a theory that generates accurate predictions. But is forecasting capability a valid criterion for accepting a theory? …
Contrary to much popular thinking, economics is not about gross domestic product (GDP), the consumer price index (CPI), or other economic indicators as such, but about human beings that interact with each other. For instance, one can observe that individuals are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street, or dining in restaurants. The essence of these activities is that they are purposeful.
Furthermore, we can establish the meaning of these activities. Thus, manual work may be a means for some people to earn money, which enables them to achieve various goals like buying food or clothing. What we observe are individuals employing means to achieve ends. By definition, human actions are purposeful, which also implies that these actions are conscious. This is an irrefutable proposition because to contradict purposeful and conscious human action is self-refuting. Ludwig von Mises—the originator of this approach—labeled this praxeology. Using the knowledge that human beings are acting consciously and purposefully, Mises was able to derive the entire body of economics.
This logically sound theory can assist in assessing the validity of the popular viewpoint that the key driver of the economy is demand. In the market economy, wealth-generators do not produce everything for their own consumption. Part of their production is used to exchange for the production of others. Hence, in the market economy, production precedes consumption. This means that something is exchanged for something else. This also means that it is an increase in the production of goods and services that allows for an increase in the demand for goods and services. Through production, the goal (i.e., demand) is reached. …
Contrary to the popular view, the market as such does not have superior knowledge. If the majority of the market participants follow misleading ideas, the market is going to display these ideas for a certain period of time until reality reasserts itself.
Even though this may be the correct conclusion, it will not be met with enthusiasm from any main stream economists or econometricians. Their theories, also found in the article, seem to be based on some unrealistic assumptions and bases. For instance, demand does not produce goods, production does but only after savings are made. This is not always recognized as being the case for economic stability and growth but, rather, ignored because it is contrary to optimistic outlooks (that keep the economy pumping, according to the current mainstream economic thought). Perhaps putting a bit more reality into economic forecasting would help in the markets!