Economists Do It With Models

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Beware Of The Marriage Trajectory, Or A Lesson On Extrapolation…

July 8th, 2009 · 11 Comments
Econ 101 · Policy

I figured, since you liked the last post so much, I would give you another one on marriage. What I had neglected to take into account with the last post is that two very dear friends of mine got married last weekend, so I am currently working on digging my way out of a literary hole. As such, I am trying to come up with a creative way to use this comic as a peace offering/wedding gift:

My friends are pretty nerdy, so a number of them pointed out the timeliness of the comic as related to our friends’ wedding. Apparently even Ezra Klein over at washingtonpost.com had something to say about it, via Twitter:

OMG, I can think of SO MANY blog uses for this comic! http://xkcd.com/605/

(Sidenote: I am amused that, when taken out of the Twitter context, the above seems to have been written by a 12 year old girl.) I am curious as to what Ezra thinks all of the blog uses are, since I’m only exploiting one of them here.

Extrapolation is a funny thing. From Wikipedia:

“In mathematics, extrapolation is the process of constructing new data points outside a discrete set of known data points. It is similar to the process of interpolation, which constructs new points between known points, but the results of extrapolations are often less meaningful, and are subject to greater uncertainty. It may also mean extension of a method, assuming similar methods will be applicable. Extrapolation may also apply to human experience to project, extend, or expand known experience into an area not known or previously experienced so as to arrive at a (usually conjectural) knowledge of the unknown [1] (e.g. a driver extrapolates road conditions beyond his sight while driving).”

Let me rephrase in normal human terms. “We collected some data. We used this data to find a supposed relationship between A and B. We will now assume that the world stays the same as it was when we collected this data and tell you what a new B will be tomorrow given what a new A is.”

Put this way, and illustrated by the absurdity of the comic, it’s clearly foolish to put a lot of blind faith in a statistic reached via extrapolation. (Note also that extrapolation is not so far removed from what people refer to as learning by induction, which loosely translates to “I watched something happen a certain way a whole bunch of times, so I conclude that that something will continue to happen in that way.”) But we get fooled easily, since sometimes extrapolation/learning by induction seems to work nicely for us. Some examples:

  • The sun rose in the east yesterday and every day before, so I conclude that the sun will rise in the east tomorrow.
  • I observe that the bank is willing to trade me two dimes and a nickel for a quarter, so I conclude that the bank will be willing to trade me two hundred dimes and one hundred nickels for one hundred quarters. (Not sure why one wouldn’t want the hundred quarters, since they could feed a lot of parking meters.)
  • I’ve observed a whole bunch of swans, and those swans are all white. I conclude that all swans are white.

Hey, wait…what was that last one again? Doesn’t some smart-sounding dude have a book called The Black Swan? How is this reasonable if all swans are white?

Actually, that’s the whole point, both of the book and of the comic…and of me, I suppose. Extrapolation and learning by induction can be valuable tools in order to try to predict future (or merely out of sample) behavior, and sometimes they are the only tools available. However, the results should be looked at critically in an effort to understand what implicit assumptions are being made in order to arrive at the stated number. Once the assumptions are outlined, debate can begin on how reasonable the assumptions are.

As an economist, I tend to get a bit defensive on this issue. People like to gloat nowadays about how all of these economic models that describe financial markets have been shown to be “wrong.” Let’s be clear- wrong would be what they would be if there was a math error somewhere. The actual problem was that the models (and the economists behind them) made assumptions about the world that turned out to not be accurate, so a better word for the models would be, oh I don’t know, inapplicable. While you can blame economists for not having a thorough enough understanding of human behavior (a shortcoming that I am working to correct thank you very much), you can’t (or shouldn’t) blame them for not having a well-functioning crystal ball, and it’s important to recognize the difference.

So lay off, okay? =P Even Alan Greenspan admitted he was wrong, sort of:

Congressman Henry Waxman: “My question is simple. Were you wrong?”

Greenspan: “Partially … I made a mistake in presuming that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms … I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works. I had been going for 40 years with considerable evidence that it was working exceptionally well. The overall view I take of regulation is, I took an oath of office when I became Federal Reserve chairman. I’m here to uphold the laws of the land passed by Congress, not my own predilections.”

Given that, you should find the following pretty funny/sad…from an old post of mine, dated September 18, 2007:

“Even Alan Greenspan is jumping on the behavioral bandwagon! Apparently he too concedes that human beings are more complex (and presumably less focused on pure self-interest) than Adam Smith professed, and he asserts that an understanding of human nature is crucial to developing suitable models of the economy. I certainly agree.”

*sigh*…

Tags: Econ 101 · Policy

11 responses so far ↓

  • 1 Larry // Jul 8, 2009 at 6:02 pm

    I think the bigger problem is that economists and others don’t understand… and those who do don’t make it clear enough… that their models not only aren’t installable but might not be applicable in the least and could actually consistently give the wrong answer.
    Our trust on Keynes to believe that the price of a good (Interest on money) could be manipulated not through an increase in supply through the build up of capitol stocks but through fancy footwork and financial strategy. Sure this might work on a very short term theoretical model but it is impracticable in the real world to say the least… economists keep advising something that is not economics… they propose that we make lead out of gold by spending our way out of problems and by having the government set interest rates at unnatural level expecting positive results. One thing economics should know by now is that no living person and no computer is smart enough to manipulate a market and consistently make it more efficient through mandate. Centralized economies don’t work and thats where economists and others got it “wrong”. Its not simply bad extrapolations its the ignoring of known fact in favor of theoretical assumptions that we are powerful enough to manipulate an economy and always have it be for the better… It was economists sadly who got this one wrong only because economists should have been screaming warnings for years that manipulating interest rates on a national level leads to improper allocation of resources and unrealistic pricing of risk.

    Interest rates in economics tie the past and future production and consumption. It is the only variable in the economy that truly ties present future consumption to present investment in production to prevent bubble and the arbitrary manipulation of that variable creates outcomes that are almost universally bad in the long run and more importantly very hard to control or predict and I blame economists not for doing these things because for the most part they didn’t but for allowing themselves to be used as pawns in this theoretical world of justifications. We as economists should have stood on the primary science of the field and warned everyone of what the risks where and very few if any did. Thats how economists where wrong.

  • 2 Don Gooding // Jul 9, 2009 at 8:04 am

    I’ll second Larry’s unease with the separation of highly mathematical economic models from realistic assumptions about the world. However, I disagree that interest rates are the only variable that affect incentives to make short-term investments for long-term rewards. Capital gains tax rates are important. The structure of executive compensation is important – and a culprit (I believe) in the recent meltdown (I had a letter to the WSJ published vis a vis my support for clawbacks). Other, more squishy things are also important, such as political stability, which is related to tax rate stability (e.g., will Democrats be increasing my taxes and lowering my incentives?).

    Also, I think the article waxes a bit Clintonian in defining “wrong.” In general you do a good job in translating complex issues into everyday language, so please don’t start being lawyerly and slicing a rhetorical distance between “wrong” and “inapplicable.” A carpenter would be wrong if he brought a hammer to do a saw’s job – it’s not that the hammer is bad, but the reason he’s wrong is his assumptions about what was needed.

  • 3 Dan L // Jul 9, 2009 at 10:43 am

    Larry, are you saying that the entire concept of central banking is misguided? I agree that the economists’ collective understanding of the thing we call “the economy” is actually quite pitiful. But that doesn’t mean that economists shouldn’t use what little they *do* understand to try to make the world a better place. You seem to claim that they end up doing more harm than good, but to say we’d be better off without central banking is just as intellectually arrogant as any central banking policy. After all, choosing to do nothing is itself a choice.

    Don, I completely agree with you regarding econgirl’s splitting of hairs between “wrong” and “inapplicable.” It’s a silly semantic point. In any case, I think that it is linguistically accurate to say that the model is “wrong.” If I build a model of a house, and my model doesn’t have the same number of windows as the house, I think it’s fair to say that my model is “wrong.” That it models some other nonexistent house accurately is irrelevant.

  • 4 Larry // Jul 9, 2009 at 2:17 pm

    Don, I will concede that Wage law effects the link between investment in human capitol and long run supply and demand almost as much as interest rates… Also progressive tax rates are just as important in human capitol investment and in my opinion progressive tax rates are a key reason for medical inflation because it kills the supply of high value professions that require massive training. I overlooked mentioning that nuance. As for capitol gains tax… it plays a roll in altering the economy but it is at least equal across all realms and it doesn’t skew the signals. My point isn’t simply that it alters or makes inefficient slightly but that it throws off the market signals. IMO capitol gains taxes have almost no impact relative to interest rate manipulation… I believe that so long as capitol gain taxes are fixed the economy can work around them and incorporate them into the price structure since they would be a long term fixed cost (thats not to say out tax code doesn’t need an overhaul because it does ).

    Dan,

    Yes, to be simplistic I am saying that the concept of central banking is misguided just the same as the concept of central planning. The government is not capable of deciding where and when investment should be made! Here is the deal, a low interest rate sends the subconscious signal to the market that capitol supply is increasing which means that national savings is growing. This allows cheap investment into future production but more importantly it signals the means for a boon in future consumption. People save to consume later. Companies see that they can borrow cheap on a national scale. Then as they pay back the debt with production revenue those investors will be spending the money creating demand for their goods (this is an aggregate scale not company size scale of signals) If national savings is climbing then it is safer to invest in future production. When central banks start manipulating the money supply and more importantly interest rates these signals get garbled and that causes misguided investment. It also creates a lack of understanding of risk because of incomplete information and a miss pricing of risk due to arbitrary price structures set by government action. Artificially low interest rates in a sector or economy leads to over investment and a bubble. Artificially high interest rates leads to under investment and shortages. Its no different than rent control in a big city… its great for a few but screws up the whole system.

    You would probably agree with me if I said that communism and other centrally planned economies have failed and likely always will. The government can’t determine utility, they can’t control price and supply and demand and relative changes and relative value of uses… these are things we simply can’t get enough information to determine. Why are interest rates different? Why are wages different? They aren’t they are prices that send specific signals to business people. These variables floating is what keeps the economy rational! When the central banks start manipulating signals they manipulate the economy and that makes everything arbitrary. I know personally I always prefer rational to arbitrary.

    Read some Austrian economics like Hayek and Mises and you will hear the side of the story that isn’t mentioned. There is no 3rd way. You can’t truly have a mixed economy! Its either government guided or it is a free market. When you mix things the signals get mixed and messed with by the government and the free market becomes meaningless. Rational people can’t make choices when the signals and signs have no meaning or relation to the real world.

    The extent of government involvement in money is to keep the money supply stable relative to GDP IMO. Some control is fine but defined and clean control with clear rules that everyone knows with the intent to be neutral in the economy is what is needed to let the market act rationally.

    Econgirl,
    I like the article in that it’s an interesting and articulate look at the problem and I don’t totally disagree I just think that economists have been misleading people for a long time… Simply because they fail to question theories and models that are yet to be proven in the real world like Keynes. Just because the math works in a hypothetical doesn’t mean it matters or should be applied… perhaps they act with good intentions but you know what they say some of the worst things have been done with good intentions.

  • 5 g4m3th30ry // Jul 10, 2009 at 2:53 am

    & this
    “I made a mistake in presuming that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms”

    I’m not sure it’s a mistake that organizations are self interested, the misunderstanding were the incentives in that market. Execs were given incentives based upon mainly short term interest of goals, so had an interest in getting fees. Easy way was through load origination.

    Then the government perverted normal banking concerns on loan defaults by quasi-backing them through purchasing them with very little oversight.

    So I can make a loan, get my closing fee, and have no downside of default.

    & to a point, they were correct – sure things were made worse when these high risk loans were packaged in MBSs and the risk was underestimated, but we only got there by rational actors working within the system the government setup.

    Cheap, easy money, very little risk in loaning it…

  • 6 Larry // Jul 10, 2009 at 2:06 pm

    Very true, I agree totally
    it was a manipulation in the price of risk that was caused by much government interference that prevented self interest from coming to bear. Freddie and Fannie started all of this by giving the housing market an unnatural amount of liquidity at an artificially low interest rate with an irrationally low oversight of risk. Reading some reports from Freddie and Fannie from 2000 to 2006 they where bragging about the numbers of people in houses… the number of minorities and “under represented groups” getting houses and how cheap they where making it for them to do it through low down or no down loans… They weren’t talking about business decisions or risk allocation they where concerned with social engineering! All you have to do is read their documents from that time frame and look at the mandates and encouragement from congress on the issue.

    It was government involvement and threat of increased regulation for social goals mixed with clouded or false signals in the form of government set interest rates and prices on risk that created this collapse! These banks never would have done this on their own!

  • 7 Dmitri // Jul 13, 2009 at 11:21 am

    @ Larry

    ‘Centralized economies don’t work and thats where economists and others got it “wrong”’ Not sure where you’re going with this, but make a look up a simple comparison of USSR per capita GDP vs that of the US circa 1990. I think there’s enough empirical work out there to conclude that centralized systems are less efficient than market economies.

  • 8 Things Economists Do When No One’s Looking, Olympics Edition… « Daniel Joseph Smith // Mar 1, 2010 at 2:09 pm

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