Economists Struggle with Facts versus Model Assumptions?
Do Economists actually have any idea of what is a fact in the real world versus what is an assumption in one of their models?
Since the beginning of the financial crisis, I have increasing come to realize the answer as it applies to Macro Economists is a resounding “NO”. (By the way, I am not alone in this. Shortly after the financial crisis began, the Bank of England’s Andy Haldane observed economists had come to believe reality reflected their models.)
As evidence of this, let me share with you a response in a recent Twitter exchange I had with two Economists.
Replying to @tyillc @DaniRodrik True. But your “transparency plus caveat emptor” model is also incomplete and can be debunked. e.g. args for “plain vanilla” contracts. 1/
Regular readers know transparency plus caveat emptor is not my model. Those two concepts are the fundamental building blocks for the redesign of the global financial system that occurred in the 1930s.
Caveat emptor was the basis for the financial system that imploded with the Great Depression. It was assumed that since investors were responsible for the losses on their investments, they would demand the information they needed to be able to assess the risk of these investments.
The Pecora Commission showed this assumption was true in theory, but not in reality. The Commission found opacity was Wall Street’s best friend.
Turning to Justice Brandeis groundbreaking work in Other Peoples’ Money, the FDR Administration redesigned the global financial system by introducing government mandated disclosure. Specifically, the government took on the responsibility for ensuring investors had access to the information they needed so they could assess the risk of an investment, know what they owned and limit their exposure to what they could afford to lose.
But could Economists, let alone anyone who took Econ 101, be expected to know these facts about how the global financial system is designed?
Is it unreasonable to expect the Economists who championed the Efficient Market Hypothesis to know how and why the global financial system is designed the way it is?
In fairness to the Economics profession, I have introduced one model. It is called the Information Matrix.
Information Matrix
| Does Seller Know What They Are Selling? | |||
| Does Buyer Know What They are Buying? | Yes | No | |
| Yes | Perfect Information | Antique Dealer Problem | |
| No | Lemon Problem | Blind Betting | |
Clearly this model is driven by a single major assumption about the availability of information to each participant in a transaction. But fortunately for me, I am able to show this assumption in the table and what the impact of the assumption is in the Matrix. (I confess there is am unstated assumption. When the buyer or seller has access to the information needed so they can know what they are buying or selling, the model assumes their decision is influenced by an assessment of this information done by either themselves or a trusted third party expert.)
With my model, I am able to explain why a financial crisis occurs and what needs to be done to end it. With my model, I am able to explain what needs to be done to prevent another financial crisis. With my model, I am able to explain why the policies put in place in response to the Great Financial Crisis have failed despite the repeated claims by government officials and former officials that these policies have been a great success. (hint: putting in place policies that create greater inequality and place the burden of the excess debt on the poor and middle class is never a good idea).
With my model, financial crises can be predicted. After all, I am one of the handful who predicted the Great Financial Crisis.
But how did the Economics profession fair with its models? As the Queen of England asked in 2008, how come the Economics profession didn’t see the crisis coming. What the Information Matrix model shows is the Economics profession couldn’t have seen the crisis coming. It couldn’t see the crisis coming because the Information Matrix isn’t taught in Econ 101 and it isn’t built into the assumptions underlying all the Economic models.
Professor Rodrik argued it is an art form to chose the right Economic model. His statement assumes the Economic profession actually has the right Economic model. As shown by the fact I developed the Information Matrix, this assumption is false.
But the Economic profession has convinced itself it has all the right answers even when it doesn’t. There are plenty of Nobel Prize winners who are willing to offer their opinion when the right answer is they don’t know because they don’t have a model that works.
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