Why Economic Models Are Always Wrong 676
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."
Obvious really (Score:4, Interesting)
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.
Very few? (Score:2, Interesting)
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 rational models are unstable (Score:5, Interesting)
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 (Score:4, Interesting)
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 [businessinsider.com] for some acknowledgement of which brand of economics has been right during the last few years. Here is another account [newyorker.com], 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 [nytimes.com].
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.
Re:Obvious really (Score:3, Interesting)
Yep, most economic models do not take actual human action into account. There are some economists that do consider human action, though (and even consider it the foundation of economics). Interestingly, those economists were the ones that did predict the current economic collapse, but were pooh-poohed and marginalized for their views.
Re:Obvious really (Score:4, Interesting)
Ah, to quote an economist acquaintance of mine "Economics isn't about numbers, it's just psychology on a mass scale" and "In school they teach us that everyone is a rational actor but everyone is completely irrational and refuses to admit it because then their models wouldn't be accurate".
All models are wrong (Score:5, Interesting)
"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
Some economics professors saw it coming ... (Score:5, Interesting)
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 [peternavarro.com]
"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.
Re:Even rational models are unstable (Score:5, Interesting)
I prefer:
Adam Curtis, The Trap: What Happened to Our Dream of Freedom, Part 2.
Re:Many people saw the economic collapse (Score:4, Interesting)
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.
Not everyone can be manipulated... (Score:2, Interesting)
False. My mother told me and my sister when we were very little that advertisements were all lies. So we watched TV looked at commercials and said "No, that washing powder is not the best, they are lying!" Etc. I remember that, and it worked although I presumably would not have been influenced anyway.
I have never bought any product because of advertising. I have only once thought in a supermarket "Hey I remember that froma commercial, perhaps I shoud try it". All other times when I want to try something new I just go for no-name stuff and/or something that seems interesting. Not because of advertising.
You mentioned Derren Brown, well, his stuff doesn't work well on me either, I've seen his programmes and almost all of it is clear to me, how he influences. It is scary how easily it is to influence people, but I will give you an example:
He tried influencing people by asking say someone in a say to show something then at the same time asking directions or something, and he had for example an expensive watch (IIRC) in his hands, then said 'It is ok' (or similar). The seller assumed the situation was ok, Derren Brown walked out of the store with the expensive watch. Later the guy in the store realised something was wrong.
The interesting thing is, I know that this doesn't work because when someone comes round to buy something I always have this feeling to be really careful and not get distracted. And no, I had never seen Brown nor anything like that before. Also, in the same episode he showed a hot dog salesman, whom he could NOT influence, he wouldn't have this "it's ok" as "Payment was made". I think a hotdog salesman will have seen the bullshit people try so much, that it's impossible to fool him.
So I think that when people get more aware of themselves and the way they are being manipulated, the less they can be manipulated.
For myself, any purchases of devices are made by going to websites to compare specs, prices, experiences of others, and of course my own wishlist of features. I am aware of how people are, thus that for example negative experiences are by nature more prominent because people are disappointed, posititive experiences usually contain little information... Advertising certainly does not work on me...
Parents should do as my mother did, and I'm sure advertising would have to change. That would be nice...