STAFF NEWS & ANALYSIS
Shock: Bloomberg Admits Models Don't Work – Economics, Government Turned Upside Down?
By Staff News & Analysis - April 11, 2013

Beware of Economists Peddling Elegant Models … Mathematics can be beguilingly elegant. It can also be dangerous when people mistake its elegance for truth. Albert Einstein's theory of general relativity might be the best example of elegant math, capturing a wide range of subtle and surprising phenomena with remarkable simplicity. Step toward the practical, though, and physics moves quickly away from elegance to makeshift usefulness. There's no pretty expression for the operation of a nuclear reactor, or for how air flows past the swept wings of an aircraft. Understanding demands ugly approximations, or brute-force simulation on a large computer. – Bloomberg

Dominant Social Theme: Hail the economists. We can indeed "model" our way to prosperity.

Free-Market Analysis: What the hell is happening at Bloomberg? How did an article like THIS ever get published by that august purveyor of statism, rational planning and "experts"?

Actually, we do know why.

Authors in the modeling camp only write articles like this very rarely – when there are replacements at hand. In this case, the author would certainly seem to be someone who believes in economic modeling, often called econometrics. Nothing has been more disastrous in the past 100 years than econometrics – except for central banking, which is a kind of econometrics itself.

The reason we say the author seems like someone of the modeling persuasion is because of his background, described thusly: "Mark Buchanan, a theoretical physicist and the author of 'The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You,' is a Bloomberg View columnist."

This is certainly an article written by a theoretical physicist, a confident screed penned by someone who has a better idea at hand. That makes it easy to reject previous models as primitive. The fault, you see, isn't with the premise but with the execution. Here's more:

In one very practical and consequential area, though, the allure of elegance has exercised a perverse and lasting influence. For several decades, economists have sought to express the way millions of people and companies interact in a handful of pretty equations.

The resulting mathematical structures, known as dynamic stochastic general equilibrium models, seek to reflect our messy reality without making too much actual contact with it. They assume that economic trends emerge from the decisions of only a few "representative" agents — one for households, one for firms, and so on. The agents are supposed to plan and act in a rational way, considering the probabilities of all possible futures and responding in an optimal way to unexpected shocks.

Surreal as such models might seem, they have played a significant role in informing policy at the world's largest central banks. Unfortunately, they don't work very well, and they proved spectacularly incapable of accommodating the way markets and the economy acted before, during and after the recent crisis.

Now, some economists are beginning to pursue a rather obvious, but uglier, alternative. Recognizing that an economy consists of the actions of millions of individuals and firms thinking, planning and perceiving things differently, they are trying to model all this messy behavior in considerable detail. Known as agent-based computational economics, the approach is showing promise.

Take, for example, a 2012 (and still somewhat preliminary) study by a group of economists, social scientists, mathematicians and physicists examining the causes of the housing boom and subsequent collapse from 2000 to 2006. Starting with data for the Washington D.C. area, the study's authors built up a computational model mimicking the behavior of more than two million potential homeowners over more than a decade. The model included detail on each individual at the level of race, income, wealth, age and marital status, and on how these characteristics correlate with home buying behavior …

The model captures things that dynamic stochastic general equilibrium models do not, such as how rising prices and the possibility of refinancing entice some people to speculate, buying more-expensive houses than they otherwise would. The model accurately fits data on the housing market over the period from 1997 to 2010 (not surprisingly, as it was designed to do so). More interesting, it can be used to probe the deeper causes of what happened.

Do you detect the hopeful, even triumphant note here? The author, giddy with anticipation, is even willing to brand the previous decades of econometrics as both "perverse" and "surreal."

These are words that might have been written by an Austrian, free-market economist – and surely they have been over and over.

Here is cold reality: Modeling doesn't work. It is impossible to design a program that takes human nature into account because every time there is an input, human reactions change. They change based on input predicted in the model but also based on inputs that are not predicted.

And even if you could predict every input – millions and millions – you would still have to calculate the SIZE of the input to make the model predictive. Otherwise, it is nothing but an analytical tool and not a workable model.

Ludwig von Mises and other Austrian economists understood this to their credit in the 20th century and Mises's Human Action is the equivalent of a nuclear bomb that, if properly circulated and understood, would forever deprive governments and central banks of a justification to exist.

No model is predictive. No model can be. Human outputs will always vary from expectations. The very act of "inputting" guarantees a contrary result.

Looked at another way, every interest rate decision handed down by central banks and every law passed by legislators is a kind of price fix guaranteed to generate an unpredictable result. This is why central bank policy always fails and why regulatory democracies gradually diminish into dysfunction and then inevitably into ruin.

Of course, Buchanan being wedded to his models – new models, actually – doesn't get into any of this. The most he does is slag the OLD models. What Buchanan cannot bring himself to admit is that the real problem is not the beauty, elegance or ugliness of models, realistic or not.

The problem is that modern human society is based on the false notion that "experts" like Buchanan CAN provide us with models that tell us accurately how to build better and more productive lives en masse. This is the true "perversity" of modern times.

We are trapped in a reality where our leaders actually believe they can "model" their way to success in a variety of fields. Even worse, they may know it isn't true – and that it is, in fact, an impossibility. This would give rise to the intuition that we are being guided by a truly cynical bunch of technocrats.

After Thoughts

Is it possible our leaders could be so cynical?

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