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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"
So small changes in inputs can produce big, unpredictable changes in the output of complex systems? It's almost as if a butterfly flapping its wings could affect the weather!
They should find a snappy name for this marvelous discovery. Something like "chaos theory".
Confucius say, "Find worm in apple - bad. Find half a worm - worse."
Many, many, many people saw the economic collapse.
I was reading plenty of blogs on the housing bubble, housingpanic.com, et etc, describing the preposterousness of "liar loans", subprime this, and idiocy that, and the crazy valuations.
The New York Times even had a plot of the inflation-adjusted Case-Schiller price index which was enormously above any prior peak. During 2006 and 2007 and 2008.
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.
The real crime is that a small number of very powerful people had an exceptionally lucrative interest in NOT stopping it, because they were getting ginormous paychecks from the continuation of the bubble. And now the notion that nobody could see it is used as excuses for the powerful to excuse themselves from responsibility from fraud and crime.
Down in the guts of banks, there were both risk modeling quants in the fancy banks, and the traditional "ladies with a bun" in the retail banks who processed the paperwork who saw how much outright fraud and insanity there was. Their jobs were threatened when they attempted to speak up and stop the madness, because the business side executives were making shitloads of shekels on volume.
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.
Actually plenty of economists did predict the crash. It's just that the only way to prevent it would have been to stop the party, and any politician who'd done so would have been replaced by someone who'd allow the credit-fueled binge to continue.
Confucius say, "Find worm in apple - bad. Find half a worm - worse."
In a religion, you just tell people what is the Truth. In science, you try to observe and learn.
The models are self fulfilling prophecies.
The high priests of the Economy tell us the Truth. The lower priests spread the word. And the people believe. Without the belief of the people, the system would instantly collapse. And if reality turns out differently, then they/we just invent a New Truth.
I mean, is it really necessary to give trillions of euros/dollars to banks to bail them out? In which pockets is that money disappearing? The bailouts are presented as "The Only Way"... but nobody actually knows.
"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
Yes.
1. The economists, who were correct were not listened to. (just look up Peter Schiff's predictions and how he was ridiculed)
2. The economists, who were wrong were listened to, because that's what everyone *wished* were true.
3. If anyone was in a position to personally gain from what was going on, they would most likely not have stopped it. So even if there were potential whistleblowers among the bankers and brokers, their incentive structure made whistleblowing a dumb move. If everything is going to s**t and you know it, but are in a position to set yourself up for life from the situation, or risk your job and your retirement saving a train that you probably couldn't stop anyway... what do you do? Be honest with yourself.
Not entirely true. Ron Paul, who until now has always been pushed aside as irrelevant to the party, predicted it clearly and concisely. He predicted what would happen, approximately when, and exactly why. And all three of those came to be. ("When" was of course inexact... nobody is claiming clairvoyance here.)
More to the point, he predicted what would happen afterward, which has also been coming to pass.
Peter Schiff, who is also of the Austrian school of economics, publicly predicted the same, back in 2006-2007. There is a great YouTube video of him arguing with Keynesians who were all basically saying "The economy is fine!"
But of course, he's not a politician. Yet.
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.
Quite a few people who had good savings still lost jobs, burned through their savings and retirement funds and in the end lost their homes anyway.
The idea that only bad or irresponsible people lost their homes in foreclosure is magical thinking. You can be a responsible person and still get wiped out
during a deep recession.
watch his speech for mortgage bankers he gave in 2006.
http://www.youtube.com/watch?v=jj8rMwdQf6k
He said that:
- implied government guarantees made dirt cheap loans for ninjas possible because they take risk out of the equation
- interest rate much below supply/demand value doesn't help either because there is too much money in search of fat profits
- nobody cared about sustainability when prices rose, if guy defaults, lender would make a profit either way
- slicing and dicing, creating MBS introduced an incentive to give as much loans as possible just to resell it to wallstreet -> lending standards being taken care of by traditionally cautious lenders went out the window
- bullshit rating assessment of MBS (lowest tranche made of the worst subprime mortgages, rated BBB- needed only 5% loss to channel the damage to higher layers)
- bubble can't go on forever, soon everybody will have a house and nobody will want to buy - price ceiling and subsequent drop is inevitable, MBS will blow up, people borrowing against their appreciating home will be soooo SOL.
Everything he said was common sense, no elaborate equations, aggregate demand and other bullshit.
Schiff was wrong pretty much about one thing (assuming narrow time horizon) - countries of the world are much more dedicated to keeping the dollar and the US afloat (by destroying their own currency nonetheless) than he thought. In the long run he is right though, you can wipe your ass with your own currency only so long (printing, excessive borrowing), especially when you have nothing to show for. Also current eurozone troubles bought the US some time.
another Austrian follower: Ron Paul
In Sept 2001 Ron Paul said that thanks to passed legislation housing bubble will form only to pop later as all bubbles do. Common sense: make borrowing cheap and subsidize housing on top of that and there will be a bubble of epic proportions.
http://www.youtube.com/watch?v=KONpt9a6HrI