Thursday, October 27, 2011

Economic Models: Comment To Scientific American

My comment to the Scientific American article, "Why Economic Models Are Always Wrong; Financial-risk models got us in trouble before the 2008 crash, and they're almost sure to get us in trouble again" by David H. Freedman:
1995 Economics Nobel Prize winner Robert Lucas wrote an influential paper in 1976 about the inability to calibrate economic predictive models. The concept, known as the "Lucas Critique," even has a wikipedia page.

The basic problem is that over the historical calibration period, an economic policy is in effect, and so the predictive results are biased by that policy. Any change to existing policy going forward is not calibrated to the historical model.

Economists correct for this by using DSGE models, dynamic stochastic general equilibrium models. These models are much more accurate because they attempt to capture expectations, future behavior, of economic agents. Thomas Sargent won the recent Economics Nobel prize for work in this field, "Rational Expectations."

Rational Expectations implies that individuals will maximize their own welfare and undo the adverse impacts of the negative effects of government policies. So, as the Fed has substantially increased the money supply, which is potentially inflationary, to boost the economy, the consumer, during this recession, has decreased the velocity of money, the money multiplier, to limit inflationary effects of the Fed's policies. Obama and Congress have attempted to stimulate the economy using government debt, so the consumer has been aggressively deleveraging, paying down debt, using credit cards much less, etc., to lower the total debt of individuals and government.

Rational Expectations implies that external, unanticipated events, will affect economic results. Economic models do not give one predictive number, as one would think from the media. The models give a range with probabilities. Too often, we only hear about the most likely number without what its probability or confidence band is, or what the range of possible values is. Even then, the world is uncertain, unexpected and strange things happen and not everything that can affect economic levels is foreseeable.

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