7/22/09

The Economist: Modern Economics is Crap

The July 18th-24th edition of The Economist has declared that modern economic theory has been a dismal failure. They cite financial economics and macroeconomics as being particularly worthless, due to the fact that most economists missed the credit bubble and are now clueless as to how to get out of the resulting Depression. Per the article, Nobel laureate Paul Krugman recently described the last 3 decades of macroeconomics as, "spectacularly useless at best, and positively harmful at worst.”


I came to a similar conclusion on 4/17: :
I have to admit that my personal animosity towards economists and finance experts has grown exponentially over the last 6 months. As I delve more deeply into the causes and assumptions that lead to the crash, I find it analogous to peeling an onion, except each layer is made of stale excrement. The recurring theme is the confident assertion that a complex process (derivative pricing, MBS risk, etc) could be accurately modeled without accounting for all inputs. Intuitively, we know this is to be false, since weather forecasts aren't useful more than a few days out. Yet, the finance industry used this reasoning to justify huge risks by proclaiming that trees could, indeed, grow to the sky.

Now, after the gravy train has derailed, we are told that there is a pundit meritocracy that must be navigated in order to hear financial truth. To which, I call bullshit: the baby and the bath water are equally offensive. These clowns have profited from leading us down the garden path twice, now. (Remember the New Economy and the viability of profitless companies claptrap they fed us during the tech bubble?) If we were to send Paul Krugman to truck driving school, the impairment to the common good isn't so apparent. Would society be that much worse off by exiling the source of The Theory of Interstellar Trade and his kind to the open road? Perhaps logistically, but I'm willing to take the hit.

The article attributes economists' inability to foresee the bubble to flawed standard models and that is almost correct. Nearly a year later, I'm still incredulous when I read about how it is nearly impossible to spot a bubble*. I'd wager that I can produce 50 people who foresaw this crisis, none of whom are economists and many lack college degrees. No model is required to see that $12/hour wage slaves don't belong in $250,000 homes or that "getting upside down" on a car loan is a hallmark of excess and unsustainable credit.
The difference is perspective and common sense.

If economics has any hope of restoring its credibility, it must return to first principles. For one, the complexity of the systems that they are attempting to measure must be respected. There is a reason that long term weather forecasts aren't terribly useful. Secondly, new models based on novel ways to misuse the standard normal distribution aren't the solution. Instead, the limitations of statistical techniques should be accounted for early in any future modeling. If said models show flaws under duress, they must be abandoned, with no regard to their eloquence. The implied volatility "smile" of any option chain should have been a damning indictment of Black-Scholes. Lastly, step away from the computer. The economy isn't in there. Nor is it in New York or DC, for that matter. Get in the car and see what 15% unemployment looks like in Kalamazoo. Spend a month working in the service economy for $8/hour and see if your concept of rationality holds. You may be disturbed by what you find, but I can promise you that a bubble will never sneak up on you again.


* Yes, I believe there is currently a bubble in the equities markets.


3 comments:

  1. No doubt the conclusion will be that even more intervention is necessary to tame the savage economic beast, and 'experts' will craft explanatory models that justify why/how.

    And chances are good that, just as in the past, people will generally accept the revisions. Until that too fails miserably as have all previous. Ground Hog Day.

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