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Monday, March 2, 2009

Economists Blame Flawed Theories and Models

In Policy Based on Failed Economic Theory: Just Stupid, I wrote:

"I can't stress how important it is to understand that economists are relying on hugely flawed theories and models when looking at the economy. Economic policy is being made off the neo-classical theory of economics.


Of course this cannot work and it never has. Neo-classical economic theory is fatally flawed from its very first basic premises. They are:

1) People have rational preferences among outcomes that can be identified and associated with a value.
2) Individuals maximize utility and firms maximize profits.
3) People act independently on the basis of full and relevant information."

I proceeded to absolutely tear into each one of these basic premises. This resulted in heated debates in the comment section.

Luckily, those in the world who can better express my mono-syllabic rage have come together to write a paper tackling these very issues.

The paper, The Financial Crisis and the Systemic Failure of Academic Economics is the outcome of one week of intense discussions within the working group on 'Modeling of Financial Markets' at the 98th Dahlem Workshop (December 14th - 19th 2008).

Abstract: The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

Section 3 of the paper: Unrealistic Model Assumptions and Unrealistic Outcomes:

[ snip ]

"Many economic models are built upon the twin assumptions of ‘rational expectations’ and a representative agent. ‘Rational expectations’ forces individuals’ expectations into harmony with the structure of the economist’s own model. This concept can be thought of as merely a way to close a model. A behavioral interpretation of rational expectations would imply that individuals and the economist have a complete understanding of the economic mechanisms governing the world. In this sense, rational expectations models do not formalize expectations as such: they are not written down as a component of the model according to some empirical observation of the expectation formation of human actors. Thus, even when applied economics research or psychology provide insights about how individuals actually form expectations, these insights cannot be used within RE models. Leaving no place for imperfect knowledge and adaptive adjustments, rational expectations models are typically found to have dynamics that are not smooth enough to fit economic data well.

Technically, rational expectations models are often framed as dynamic programming problems in macroeconomics. But, dynamic programming models have serious limitations. Specifically, to make them analytically tractable, researchers assume representative agents and rational expectations, which assume away any heterogeneity among economic actors. Such models presume that there is a single model of the economy, which is odd given that even economists are divided in their views about the correct model of the economy. While other currents of research do exist, economic policy advice, particularly in financial economics, has far too often been based (consciously or not) on a set of axioms and hypotheses derived ultimately from a highly limited dynamic control model, using the Robinson approach with ‘rational’ expectations.

The major problem is that despite its many refinements, this is not at all an approach based on, and confirmed by, empirical research. In fact, it stands in stark contrast to a broad set of regularities in human behavior discovered both in psychology and what is called behavioral and experimental economics. The corner stones of many models in finance and macroeconomics are rather maintained despite all the contradictory evidence discovered in empirical research. Much of this literature shows that human subjects act in a way that bears no resemblance to the rational expectations paradigm and also have problems discovering ‘rational expectations equilibria’ in repeated experimental settings. Rather, agents display various forms of ‘bounded rationality’ using heuristic decision rules and displaying inertia in their reaction to new information. They have also been shown in financial markets to be strongly influenced by emotional and hormonal reactions (see Lo et al., 2005, and Coates and Herbert, 2008) Economic modeling has to take such findings seriously.

What we are arguing is that as a modeling requirement, internal consistency must be complemented with external consistency: Economic modeling has to be compatible with insights from other branches of science on human behavior. It is highly problematic to insist on a specific view of humans in economic settings that is irreconcilable with evidence."

[ snip ]

Related, Interesting Books:
Beyond Greed and Fear: Finance and the Pschology of Investing
Predictably Irrational : The Hidden Forces That Shape our Decisions
The Drunkard's Walk: How Randomness Rules our Lives
Outliers: The Story of Success


michael said...

In my opinion all nice theories have one main flaw:
They ignore or underestimate participants will to game the system!