Andrew WhiteThe Economist did it again for me last weekend. My Economist (print edition, July 18-24) arrives Monday afternoon, but if I am lucky, it arrives with the Saturday mail. It this last weekend so that means I get the pleasure of a quite read without any pressure to check emailJ. Two articles looked at the fall of economic theory that has come with the current economic climate. The two articles are:
For me, the bottom line is “models” and “assumptions”. I think I must be a closet economist; the very idea that we can model how our economy works is just amazing. I play a lot of PC games, which implies my brain loves to solve problems and loves to test the boundaries of models (the game) designed by other people. I think therefore the idea that the economy is a self-organizing game that we try to model is just amazing.
It seems current macroeconomic models, in use at the highest levels of policy and theory, made some assumptions that proved incapable of arming the users with what they needed. Many models assume or include the notion of:
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Any impact of asset prices (they model products and services only)
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The impact of insolvent banks or financial organizations
Other models assume:
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“price” exists for every product/service, at ever level of demand, for every point in time (what is called, a “complete” market)
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Price* of a thing reflect all available information that is relevant to its value
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Humans, or agents, are rational; a new branch of economists look more at behavioral psychology (since we do things that do not look rational, but in fact are).
* The idea that price is a proxy for all information needed to derive an assets value is a key point. Some accounting models allow for “write off’s” based on the difference between what was paid (when acquired) and when it is sold; others allow for the right off during its lifetime as its price changes (in this case, falls). There is no right approach; each approach leads to different behavior.
Did you know that there is an abnormal increase in elective surgical work? It seems that humans are behaving rationally – many are assuming a high risk of losing their job and hence medical insurance, and are therefore “getting in early, just in case”. This is what some economists call irrational – yet it is very human response. Explain that one!
Excellent articles – well worth reviewing. If you enjoy them, explore adaptive market hypothesis, proposed by Andrew Lo of MIT.
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2 responses so far ↓
1 Bob Kitzberger July 29, 2009 at 5:40 pm
Thanks for the pointer to these articles, Andrew. Very interesting articles (and I like the observation of economic models being similar to the models underlying games – something that is exploited in business simulation games for MBA students).
The Economist calls the division of opinion in modern economics “unfortunate”. But is it? I look to Hegel’s dialectic progression as a model for improving understanding of how the world – or economies – work. The opposition of opinion acts much like competition in the markets, driving us to better understandings. Without it we have the ‘brackish’ stagnation of economic thought described in the article.
Please keep up the broad postings – a nice break from data plumbing.
2 Andrew White July 29, 2009 at 5:51 pm
Hi Bob,
Thanks for the post. Good point – are we really ever “wrong” or are we forever tuning out understanding of how the world works. Maybe both views are supported – depending on your position. But I love the idea that assumptions of models, or some of them, get hauled over the coals as “wrong”.
When I play real time strategy games, and I make assumptions about how the AI will play (or the human player), and sometime later I get dinged (lose a battle, lost a base, fall behind – whatever) then I realize I have to re-do my assumptions. So the gaming idea, and the complexity of the models, is great fun to explore.
One of my favorite games is Capitalism 2.0 – an old game that used to used in educational establishments. I once took an industrial management course (in the UK, Cornwall University I think it was) where a simpler version was played as part of the financial training. Its a great model for how a small, closed economy works – or at least how a few firms interact with finite supply of raw materials and goods and demand variability.
I hope I come back as an economic modeler…I’d love it! Then again, I would not have had the pleasure of talking about MDM (which goes to the heart of the data within the model)