Thursday, May 27, 2010

Beware Of Economists Bearing Predictions From Models

Max Borders explains (emphasis added)

"So what do all these macroeconomic models have in common?

-They’re rendered either in impenetrable math or with sophisticated computers, requiring a lot of popular (and political) faith.

-Politicians and policy wizards hide behind this impenetrability, both to evade public scrutiny and to secure their status as elites.

-Models vaguely resemble the real-world phenomena they’re meant to explain but often fail to track with reality when the evidence comes in.

-They’re meant to model complex systems, but such systems resist modeling. Complexity makes things inherently hard to predict and forecast.

-They’re used by people who fancy themselves planners—not just predictors or describers—of complex phenomena."

The point is, according to Richard Ebeling, ``The inability of the economics profession to grasp the mainsprings of human action has resulted from the adoption of economic models totally outside of reality. In the models put forth as explanations of market phenomena, equilibrium — that point at which all market activities come to rest and all market participants possess perfect knowledge with unchanging tastes and preferences — has become the cornerstone of most economic theory."

Yet many people stubbornly refuse to learn from the lessons of the last crisis.

The mainstream hardly saw the last crisis from ever occurring:

This is why the Queen of England in 2009 censured the profession's failure to anticipate the crisis.

This also why US investment banks became an extinct species in 2008 as remnant banks were converted into holding companies, as losses strained the industry's balance sheets, which forced these banks into the government's arms.

This also why Ponzi artist Bernard Madoff gypped, not only gullible wealthy individuals but importantly a slew of international financial companies.

And this is also why contrarian John Paulson was able to capitalize on shorting the housing bubble via Goldman Sachs, which became a recent controversy, because the other side of the trade had been 'sophisticated' financial companies.

In retrospect, not only was the mainstream composed of highly specialized institutions, which were not only model oriented, but had an organization composed of an army of experts that have not seen, anticipated, predicted or expected these adverse events.

It is also important to point out that not only are the models unrealistic but those making these models are people with the same frailties whom they attempt to model. These people are also subject to the same biases that helped skew the models, which they try to oversimplify or see constancy in a dynamic world. They are also subject to Groupthink and the influences of Dopamine in their decision making process.

Adds Mr. Borders, (emphasis added)

``What does this mean for economics as a discipline? I think it’s time we admit many economists are just soothsayers. They keep their jobs for a host of reasons that have less to do with accuracy and more to do with politics and obscurantism. Indeed, where do you find them but in bureaucracies—those great shelters from reality’s storms? Governments and universities are places where big brains go to be grand and weave speculative webs for the benefit of the few.

``And yet “ideas have consequences.” Bureaucracies are power centers. So we have a big job ahead of us. We’ve got to do a seemingly contradictory thing and make the very idea of complex systems simple. How best to say it? Economists aren’t oracles? Soothsaying is not science? Ecosystems can’t be designed?

“The very term ‘model’ is a pretentious borrowing of the architect’s or engineer’s replica, down-to-scale of something physical,” says Barron’s economics editor, Gene Epstein. “These are not models at all, but just equations that link various numbers, maybe occasionally shedding light, but often not.”

Bottom line: Incentives and stakeholdings largely determine the mainstream's fixation to models.

Many are driven by ego (desire to be seen as superior to the rest), others are driven by politics (use math models to justify securing the interests of particular groups), some by groupthink (the need to be seen in the comfort of crowds), some because of personal benefits (defense of political or academic career, stakeholdings in institutions or markets or businesses) and possibly others just for the plain obsession to mathematical formalism.

At the end of the day, logic and sound reasoning prevails.

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