Why Economic Models Are Always Wrong 676
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samzenpus
from the soft-science dept.
from the soft-science dept.
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."
Economics... (Score:4, Insightful)
... is not a science. The legal structure of money, the way prices work in a one way fashion, and private ownershp are all political all the way through. Now this may piss off Americans but there are alternative ways to organize society whether they like it or not. Human beings tend to be people of their era and they often have a profound lack of imagination, the black and white right/left thinking I see from people already disqualifies them for not even having the courage to analyze or think about the structures and societies in which they find themselves, the false notion that it is either THIS/THAT, BLACK/WHITE is having given up critical thinking and analysis for good.
Many people saw the economic collapse (Score:5, Insightful)
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.
Re:Economics... (Score:5, Insightful)
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.
Economy is a religion, not a science (Score:5, Insightful)
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.
Re:Obvious really (Score:5, Insightful)
Just ask Derren Brown if people are predictable. If you think people cannot be modeled, you are deluding yourself. Adam Smith saw it, and came up with a revolutionary theory that worked. Amazingly enough, his model assumes that all people act in their own self interest.
Of course, the way you interpret the 'self interest' is what varies, but I am pretty sure that for the majority of humans self interest is fairly narrowly defined.
Saying that every human is unique and special is like saying you're immune to commercials. It's just wishful thinking.
See comments below. The crash was predicted. People acted in a predictable way.
Re:Obvious really (Score:2, Insightful)
Or, statistical predictions don't require knowing the exact behavior of each agent, and expectation values can take you a long way.
Re:Economy is a religion, not a science (Score:1, Insightful)
Wait... I wrote "only possible". That's not true. Another possible reason for its existence is that it gives the rich and the politicians instant access to virtually unlimited, as-yet-uninflated dollars at somewhere between low and no interest.
Well... whichever one you think is the greatest cause. Whatever that may be, it certainly isn't viable as a real economic theory.
Re:Obvious really (Score:5, Insightful)
Nice analogy, but physicist don't have to worry that the CEO molecule in an apple might die.
Re:Obvious really (Score:4, Insightful)
Real world data is not going to be an exact fit to any arbitrary type of curve. It might be part of a sine wave, but it could be a quadratic or a quartic; there might even be an odd power with a small coefficient. Which do you choose? It might not be important within the range of data that you have, but once you move outside it might.
Even if you could have "perfect data", you're only taking into account some of the variables involved. Your model would be perfect but partial. One of the factors that you ignored might not have had an effect in the past, but it might be precisely the one that makes it different next time.
Re:Even rational models are unstable (Score:4, Insightful)
actually, there were a lot of people talking about the future mortage crisis way before it became apparent.
the problem is that there will always be biased economist with an agenda, whether they are supporter of the status quo or naysayer, the same way there are biased climate scientist both in the pro warming and negationist crowd.
the problem are the we can't distinguish between unbiased and biased, we can't truly understand their models and thus we cannot discriminate between genuine models and biased ones.
we can only catch blatant lies, but while it easy on hard sciences, it's quite hard on social models.
we can just make sure to avoid blatantly biased studies, but it's not enough to find out who is who, specially because most economist work is known by news and not by papers, specially works that tackle the situation at hand instead of the general situational trends.
In many cases It still made no difference (Score:5, Insightful)
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.
Re:Could psychohistory be the answer? (Score:5, Insightful)
watch his speech for mortgage bankers he gave in 2006.
http://www.youtube.com/watch?v=jj8rMwdQf6k [youtube.com]
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 [youtube.com]
Re:Even rational models are unstable (Score:5, Insightful)
Re:Many people saw the economic collapse (Score:4, Insightful)
Even of you do accept the ludicrous notion that small number of people *could* have stopped it.
Actually, the notion is that, if a relatively small number of people had not prevented it, a somewhat larger group of people could have acted to ameliorate the consequences of the bubble popping.
The people who should be held accountable for the bubble and the negative consequences of it popping are not (at least for the most part) the bankers. The politicians who started the bubble inflating and then when other politicians tried to let some air out of the bubble used their positions to prevent that are the ones who should be held accountable. There are, also, bureaucrats at Fanie Mae and Freddie Mac who should be held to blame as well. Most of the bankers, while they were happily raking in the profits from the bubble, were not in a position to change the dynamics of it.
What I find most interesting about those who blame the bankers for the situation is that they tend to favor Democrats, just like the bankers most involved in the financial meltdown.
Re:Even rational models are unstable (Score:4, Insightful)
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.
Hell, even if it were the case that there were a point when people acted in a totally predictable fashion, despite or because of the existence of the model, there is still another issue. Any sufficiently high quality economic model will be modeling a chaotic system. By definition chaotic systems are extremely sensitive to initial conditions. Even if your model has the parameters perfect, if you are even slightly off in your initial conditions the output can differ enormously. This is actually made worse by the fact the the chaotic portion of the model often has minimal impact on the output most of the time, but other times it becomes a dominant factor.
For example, chaos becomes a dominant factor during a catastrophic market collapse, since the exact order of events (what company's go out of business in what order, whose stock prices drop the most before regulators freeze trading, etc) is extremely sensitive to initial conditions, and the order of events determine whether certain events occur at all. If the order of events allows one of the big players in said market barely managing to remain in the game vs them going out of business can make an enormous difference in how quickly said market can recover.
Re:Even rational models are unstable (Score:4, Insightful)
Maybe, maybe not. Many lenders knew very well that their loans would go bad - they called them "liar's loans" even at the time! And many bankers knew the derivatives they created from those bad loans (which they sold back and forth to reach a leverage of about 30x) were not worthy of the AAA rating the ratings agencies gave them.
But here's the thing - a race to the bottom is not averted by knowing it's happening! If you don't think the other guy will stop even if you do, then your best option is to get while the getting is good, before the sh*t hits the fan.
Plus, the outcome wasn't disastrous for those at the top - at worst, they lost their jobs, and walked away keeping the millions they had "earned." They need never work again.
So, even perfect knowledge would not guarantee a good outcome.
Re:Obvious really (Score:2, Insightful)
Statistical mechanics works because when molecules interact they do so in probabilistic ways that you can easily work out
No. Statistical mechanics works because when you average the interactions of the millions of molecules, the result is predictable. Many of the interactions do NOT happen exactly as one might predict, but some act "unpredictably" in one direction, and some "unpredictably" in another.
In the same way, we do not need to know which individual person did something stupid on the freeway to determine that once there is critical density of traffic, someone tapping their brakes at one point will cause a cascade effect that leads to a full-stop situation for the freeway a few miles back [speroforum.com].
Humans don't operate like that. Human interactions are, shockingly, more complex than a molecule bumping into another.
That's irrelevant. Individual humans behave unpredictably. People, en masse, behave in ways that are actually highly predictable because the unpredictable actions of one person are balanced by the "unpredictable" action of another person doing something relatively opposite.
Re:Obvious really (Score:4, Insightful)
No, sometimes your personal gain also benefits the community.
If it does then the standard economic model will see it as rational because of the personal gain.
Plus, there are always altruists who get a warm fuzzy (personal gain) from doing good (helping the community).
Yes, and I consider that to be rational, or at least possibly rational. The standard model of human behaviour used by economists, on the other hand, judges that to be irrational behaviour. That's my point: economists use a specific definition of "rational" that doesn't match very well to everyone else's.
But, in large, it's fairly safe to say that everyone is more interested in things that IMMEDIATELY benefit them than they are in things that IMMEDIATELY harm them but benefit others. Hence our general aversion to taxes, tariffs, etc.
Not as safe as you might think. At very least, you can't limit it to material benefits. Research has shown pretty consistently that (in market-based cultures) most people are willing to take a modest financial "hit" on a transaction in order to spite somebody who has treated them badly. Economically that is described as "irrational" behaviour, but all it actually means is that spiting the offender has value. What's more, that behaviour can be shown to be adaptive at the group level, because punishing "bad" behaviour discourages such behaviour, which is to the benefit of the overall community even if those two individuals never do business again.
Re:Economics... (Score:4, Insightful)
Actually, economists predict crashes all of the time.
For instance, right now there are some people predicting a UK housing market crash of about 20% in the next year. If theres no crash this year, they'll just move forwards to next year. Eventually they'll be right, and will parade their insight for all to see.
WTF are you talking about? (Score:4, Insightful)
Game theory always does account for things like that, primarily because the behavior you're describing is not irrational. The very fact that you are predicting that "he gets ahead" is what makes it rational.
Same for your "when they zig, you zag" idea: I have never heard of anyone using game theory that doesn't account for (and in fact, predict) that sort of behavior.
If you want to come up with an example where game theory doesn't work, you're going to have to try a few thousand times harder than that.
The reason game theory tends to disappoint, is that peoples' intuitive hunches for the payoffs of certain actions don't match the theory, but those hunches are what they act upon -- and that in turn changes all the payoffs, sometimes toward causing the hunches to becomes true (!) and sometimes toward causing the hunches to be more false. And that itself can be analyzed and predicted, but only if you just happen to know what other people's hunches are going to be -- and that is never predictable.
Game theory is about finding optimum equilibriums for behavior; it can never tell you what people believe.
BTW, back onto GP's subject.. a few months ago I went on an AdamCurtis-athon with some high expectations. It was a letdown, and not nearly as serious a criticism of the targets as I had hoped, especially since I just assumed some of them (e.g. the neo-cons) would be shooting fish in a barrel. I won't say watching all his docs is a waste of time -- it's not -- but don't get your hopes up. You'll find some good anecdotes, carefully selected interesting trivia, and great quotes like the one about economists and psychopaths .. but that's all.