My Two Theories

21 12 2010
The “great man” theory was very popular in the 19th and early 20th century, when the world was a bit smaller and the headlines dominated by fewer personalities.  The basic concept of the theory was the charisma, power, and influence of a few ‘heroes’ could change the face of the Earth.  In recent times, this theory has been discounted by many, as the social environment was argued to be influential on these ‘great men’, instead of the other way around.  Over the last few months, I’ve done a considerable amount of thinking and research on the economic collapse and how models could be improved to prevent this in the future.  I think the short answer is, “economic models suck and are mostly useless in today’s society”.  Like the “great man” theory, these models need to be discredited as being too simple of a view on our reality, and must be improved.  Luckily, I believe technology will come to our aid (as it normally does).  The question is – will these technological advancements be taken seriously?  The two theories I’ve sketched out below argue that without a serious awakening (like the recent downturn should be?) economists will not change their basic models and begin making realistic predictions.

The first I call “the little man” theory.  The purpose here is to turn the “great man” theory on it’s head.  Instead of concentrating on the big players and personalities, there needs to be a re-focus onto the little players.  Essentially, economic models tend to leave out everything that makes our society today (like small banks, individual purchase practices, etc.).  This creates an imbalance when we are analyzing expected economic behaviors.  For example, lets say we are watching FOX news and they are looking at what the models expect spending will do based on a certain political decision.  We tend to believe these ‘models’ because people with PhD’s make them.  However, the truth is that they leave out most of the details on the granular level and instead concentrate on how the largest firms and groups of people will be affected.

The ‘little man’ is what gets squeezed here.  We take actions based on models that don’t take into account how it will affect the small players (AKA the majority of the US population).  Instead, we look at what will benefit the short-term focused major banks and institutions, so that we can report better earnings on TV.  For example, I’m sure you can find a ‘model’ that says eliminating derivatives trading will have a catastrophic effect on the economy.  What you should read that as is: “eliminating derivatives trading will cause the major banks to report fewer earnings and assets, which could make for more flat growth on our graphs”.  Eliminating derivatives trading would protect the ‘little man’ whose chance of profiting on derivatives is small, especially since he has access to less information than the major market players.  It would also force banks to invest more of their capital in opportunities that, while not providing the type of frictional revenue that derivatives trading does, would provide more long-term value to society (think more green tech and small seed startups).

The second theory is the “too messy” theory (notice my incredible naming conventions).  In reality, this is almost a corollary, or second part of the first theory.  This theory argues that the reason models have not been updated, and why our political actions rarely have their intended consequences, is that the models we have are oversimplified versions.  The real models would be ‘too messy’ for most economists.  The economists of the past have left out large portions of ‘reality’ from their models.  Real ‘dynamic stochastic general equilibrium’ models should attempt to include all of the equations and players that make reality what it is – not what a simplified drawing of it on a board might look like.  Economists have clinged to the simpler model, since they can easily manipulate it, perform sensitivity analysis on it, and comment on it.  Since they can say things like “well our model would show this” they never have to show the underworkings of the model.  In reality, an effective model would be difficult to comment freely on, since it’s complexity means that any variable change would have to be re-run to be properly accounted for.  While this doesn’t make for “good TV”, it’s necessary if we are to base our assumptions and actions on these models.

The best way to clean up these models is to integrate the advanced mathematics Doyne Farmer and his team are working on (read more in his book The Predictors, and here).  He argues that we must create “a richly complex, computer-based simulation of the economy like those scientists use to model weather patterns, epidemics and traffic. Given enough computing power, such “agent-based” models can include millions of individual players, who don’t have to be rational or agree with one another.”

What is right is not always easy. Sorry economists, looks like you have some work to do.
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