Tuesday, October 4, 2011

Uncertainty, Complexity, And The Problem With Economic Models

Nick Rowe has a headache (excerpt):

The Lucasian map is not the Hayekian territory

In defence of Lucas '72.

Take any macroeconomic model of a market economy with inefficient aggregate fluctuations. In fact, take any economic model where something bad might happen.

Assume that model is literally true.

The people in that model are idiots.

This conclusion follows immediately. If they weren't idiots, the people in the model would appoint the economist modelling the economy as central planner, who would tell them all what to do, and make them all better off.

The people in Lucas' '72 model are complete idiots for producing less because they don't realise there's a recession on.

The people in New Keynesian models are complete idiots for waiting for the Calvo fairy to give them permission to cut prices in a recession.

All models suffer this same problem. If the world really were as simple as the economic model of that world, people would figure it out, and wouldn't let bad things happen.

Of course, the discussion doesn’t go so far as to say that all economic analysis is useless – we know more about how people interact individually and in aggregate than we did before. But it’s always useful to keep in mind the inherent tension between a highly complex real world teeming with sometimes irrational individuals, and the oversimplified world of economic modelling. And you should always also take into account the biases of the modeller.

But, to quote George Box, “Essentially, all models are wrong, but some are useful."


  1. Exactly..
    Looking through the EPPs ,I am just astounded at the EBITDAs as % of Revenue..60-120%.inordinately high & not market driven.Thus the modeller expects competitors to hv their hands tied,eyes blindfolded.

    But these are seasoned guys giving the imputs n doing the crunching.Pemandu guys are short of grey matter but talks a storm thus are pretty easy meat for the biz guys.

    So whats the catch for the modellers? maybe its the enablers and facilitation.Of course,once the PM validates your proposal,doors are opened.PM will be too embarrassed to admit thay myb myb some of the ideas are a bit skewed,

    Prime example is a viable MRT financed by private sectors quietly becomes public funded.But the promoter gets the cream i.e via direct nego PDP n tunneling Swiss Advantage.

    Beware the modeller indeed.

    It is the responsibility of all the best & smart independent brains in Msia to expose the farce.

  2. Can the national economy be micro managed to the extend of identifying "Projects" n private investments/growth.

    Basically you will impose business interest to the rakyat.Capital rules the policy..so it goes beyond Capital v Labour.

    I think najib got it all wrong.