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Why Economic Models Are Always Wrong
mayberry42 writes "Did you ever wonder how and why professional economists often seem to get it wrong in terms of predicting consequences or policies accurately (or even at all)? Or how very few even saw the current economic collapse? This article provides an interesting, if obvious, reason as to why economic models are effectively always wrong."
Most economic models are based on "how we would like people to act" rather than "how people actually act". Much of the time, the model works, but they fail when people act in irrational ways.
Simples.
"She's furniture with a pulse"
Few people saw the collapse coming? Really?
All you had to do was turn on some form of broadcast radio after about 1995 and listen for a little while. When the commercial break appeared you heard one mortgage mill after another hawking refis, credit lines, etc. Bad credit? No credit? No problem! Interest only mortgage. Balloon mortgage. Jumbo mortgage!
This went on for years and years.
I saw it coming. If you missed it you're a fool. Maybe we just have a lot of fools.
Even if everyone acted rationally, you would then have the instability which is generated because all of these rational people would then change their behavior based on ... the model. It's unclear, and in my eyes rather unlikely, that a "fixed point" exists where all of these rational people start behaving identically and predictably.
The unpredictability doesn't only come out of irrationality. If you look at game theory, you see that many optimal (i.e., rational) strategies are "mixed" strategies where the rational party necessarily behaves probabilistically, not deterministically.
Models aren't equal to models, and even rough models of chaotic phenomena can be very useful and predictive, if they are the right ones. Read this for some acknowledgement of which brand of economics has been right during the last few years. Here is another account, including some pointers to predictions of the current crisis reaching as far back as 1999. Krugman even has a "model" of how good models get out of fashion.
Economics suffers from the manipulation by political interests, and by the wish of many practitioners to project their moral ideals onto the world. Many economists simply go and try to prove that the world works however they want it to work, and find funding for that from rich supporters. That makes the endeavour biased.
"Remember that all models are wrong; the practical question is how wrong do they have to be to not be useful." (George E.P. Box and Norman R. Draper, Empirical Model-Building and Response Surfaces (1987), p. 74)
"One of the most insidious and nefarious properties of scientific models is their tendency to take over, and sometimes supplant, reality." (Erwin Chargaff)
I think that says it all, really.
--Bud
Many, many, many people saw the economic collapse.
A newsletter from an economics professor and CNBC financial commentator: ...
Any talking head who tells you that this market is a buying opportunity has his/her head screwed on backwards. The only buys are the kind of value plays that the likes of Buffett are pulling off. That is, it is very much a stock picker’s market.
Recession plus inflation plus a credit crisis plus a softening European economy plus an inflation-plagued Chinese economy plus Russian strong-arming in natural gas plus two leading presidential candidates who are ignoramuses on economics plus a rising long bond in the face of Fed rate cuts does not a bull market make."
http://www.peternavarro.com/2008.02.01_arch.html
"Thursday, February 28, 2008
That is his oldest newsletter but I understand he was telling his economics students to "get out" of the market in fall 2007. Plus he was showing them a whole bunch of historical indicators that were all pointing in the wrong direction.
The notion that "nobody" saw it is simply propagandistic truthiness baloney. I personally didn't profit, because I was much too early shorting the mortgage companies & home builders and got stopped out---the bubble was too powerful.
Which actually brings up the real problem, bubbles are actually pretty easy to spot, but almost impossible to time. Like you said, a lot of people saw the bubble, but almost nobody predicted when it would actually burst(a couple did, but the % is so low that it can be chalked up to random chance). You short too early and you end up in a bind as your trades are called in, too late and you missed all the fun.
For a current bubble, look at the Japanese yen. There is no way the yen should be as high as it is right now, there is obviously a lot of leveraging going on keeping the currency much stronger than it should be. The currency will snap back, and probably pretty violently due to the massive amount of leveraging, but every single "prediction" I have read of when this will occur has been wrong.
Monstar L