Economics is a queer subject. I like to boil things down to the very basics whenever I am trying to learn something new, doing research or teaching, as the students on the CQF can attest—think of some of my stranger analogies, guys! But this doesn’t work with economics. Starting with a couple of blokes in a cave, one of whom has just invented the wheel, try to imagine the exchanges that take place and how that turns into General Motors. No, it makes my brain hurt. No matter how much red wine I’ve drunk it doesn’t seem to work.
And I’m supposed to be clever. Why am I incapable of understanding economics, a straightforward enough subject that it’s even taught in schools?
My failure led me to think about economists, as opposed to economics, and they’re much easier to figure out. This is how it works. An economist starts with a few axioms, ones that bear a vague similarity to a small part of the human condition under restricted situations and in an idealized world. (You get my drift here?) From those axioms follows a theorem. More often than not this will be a theorem based upon rational behaviour. That theorem gets a name. And that’s the point I identify as being the problem: The jargonizing of complex ideas based upon irrelevant assumptions into an easily used and abused building block on which to build the edifice of nonsense that is modern economics.
Small assumption by small assumption, the economist builds up his theories into useless gibberish. By acceptance of each step he is able to kid himself he is making progress. And that’s why I struggle with economics. It is not mathematics where, barring mistakes, each step is true and indisputable and therefore you can accept it, even forget it, and move on. And others can do the same, using everyone else’s results without question. This you cannot do in a soft science. I’ve mentioned this in another blog, beware of anyone talking about ‘results’ in finance or economics, it says more about them and their perception of the world than it does about the subject.
Not so long ago Alan Greenspan famously said he had found a flaw in the “critical functioning structure that defines how the world works.” “I don't know how significant or permanent it is but I have been very distressed by that fact.” Ohmigod! His naivety and lack of self knowledge is staggering. He has fallen into the same trap as other economists. By believing the theories he has believed the axioms on which they are based. The edifice of nonsense has collapsed on top of one of its builders.
You beautiful, complex, irrational people! Please, promise me that you will continue to violate every axiom and assumption of economics, maybe not all the time, that would be too predictable, but now and then, just so as to keep those pesky economists on their toes!
Greenspan also said that risk models and econometric models are still too simple. Lord, help us!
Let me tell you a story.
A decade or so ago I was browsing through the library of Imperial College, London, when I happened upon a book called something like “The Treasury’s Model of the UK Economy.” It was about one inch thick and full of difference equations. Seven hundred and seventy of them, one for each of 770 incredibly important economic variables. There was an equation for the rate of inflation, one for the dollar-sterling exchange rate, others for each of the short-term and long-term interest rates, there was the price of fish, etc. etc. (The last one I made up. I hope.) Could that be a good model with reliable forecasts? Consider how many parameters must be needed, every one impossible to measure accurately, every one unstable. I can’t remember whether these were linear or non-linear difference equations, but every undergrad mathematician knows that you can get chaos with a single non-linear difference equation so think of the output you might get from 770. Putting myself in the mind of the Treasury economists I think “Hmm, maybe the results of the model are so bad that we need an extra variable. Yes, that’s it, if we can find the 771st equation then the model will finally be perfect.” No, gentlemen of the Treasury, that is not right. What you want to do is throw away all but the half dozen most important equations and then accept the inevitable, that the results won’t be perfect.
A short distance away on the same shelf was the model of the Venezuelan economy. This was a much thinner book with a mere 160 equations. Again I can imagine the Venezuelan economists saying to each other, “Amigos, one day we too will have as many equations as those British cabrones, no?” No, what you want to do is strip down the 160 equations you’ve got to the most important. In Venezuela maybe it’s just one equation, for the price of oil.
We don’t need more complex economics models. Nor do we need that fourteenth stochastic variable in finance. We need simplicity and robustness. We need to accept that the models of human behaviour will never be perfect. We need to accept all that, and then build in a nice safety margin in our forecasts, prices and measures of risk.
Happy New Year!