Friday 7 March 2014

Unfit models

In a recent conference about data analysis, I highlighted the importance of being well aware of one’s model’s assumptions. That all models are wrong should not be a reason never to use them, but you must be acutely aware of what their use implies.

I trust that you would agree with such an observation (OK, some will not want to use imperfect model at all, but that is going too far, and would have prevented any progress in human knowledge). But if you do, you should be pretty worried. Because most developed countries (and probably even more so less-developed ones) are now run on the basis of models whose assumptions are wildly violated –to the point where the rules of such models have made their way into their constitutions.

Let me take only three examples:
-The use of monetary versus fiscal means
-The use of markets to approach a social optimum.
Of course, we know that people are not “rational”, for the economic meaning of rational, so pretty much all economic models could be argued to be false from the start. But they have sometimes been able to give valuable insight despite that major weakness. In many cases, the difference was more in degree than in kind. Other assumptions, however, will see the direction of the effect altered when violated –as they are, as we shall see.

1. Monetary economy management

That is the most obvious these days. The argument for using monetary means rather than fiscal ones boiled down to the idea that, whatever fiscal means could achieve, monetary ones could too, except more efficiently.
I would argue that this is simplistic –for instance, managing the economy should go beyond having targets for inflation, unemployment, maybe GDP, and monetary means will struggle to go far beyond that. Still, let’s see how this was supposed to be.
In summary, the Central Bank would lower its rates to boost lending/ reduce savings when the economy needed more spending. Fiscal action was even deemed to be entirely neutral as the Central Bank would adjust its rates accordingly to meet its objectives. So you could even reduce deficits in a recession as the rates would be lowered accordingly, so that it would have no adverse effects. People argued those points so forcefully (that their argument favoured the already wealthy was no doubt a coincidence in its eventual success) that fiscal action has essentially been made illegal in the Eurozone.
Ahem. Interest rates cannot go meaningfully below zero (it might be possible to effectively bring them down to -.2% with very unusual action). So what if we are in a situation where you are already are at, or incredibly near zero, yet monetary policies would demand you lower rates? You pretty much cannot, short of introducing new types of money that regularly lose value (a very cumbersome proposition). So, even in the simplistic frame where one only looks at easily managing GDP, monetary actions struggle to get any traction anytime the target interest rate is negative. Yet not only is the assumption that monetary adjustments will just make fiscal action neutral everywhere in economic models, many countries (the UK and the Eurozone come readily to mind) have passed legislation or even constitutional amendments banning fiscal stimulus and “assuming” the desired macroeconomic situation from monetary actions.

2. Microeconomics

It would not be obvious to people who have never had a course in microeconomics, but they are built on the assumption –nay, they depend on it- of full employment.
It’s everywhere, but let’s see a couple of obvious examples.

A recurrent explanation in favour of trade (yes, New Economic Geography tenants, I know it obviously doesn’t fit the facts, but that’s sort of my point, even if there are also other reasons than the full employment assumption for it to violate the real world) is the theory of comparative advantages. If a country (or region, or city, whatever) is much better at producing A than another, and only a little better at producing B, then it can produce more of A and trade with the other country to get its supply of B, and both countries will be better off, as the other country will get to produce more of B, at which it is, comparatively, better than A. Right, there is the small problem of retraining, but some economists will tell you that it should be understood in the long run (what happens if those products have an existence of only a few years, as is increasingly common? Don’t ask). 

Even conceding all of that, which is a lot, there is a little problem: what if the first country simply has some of its unemployed workforce produce more of A, rather than needing B producers to switch? Ah, but it could not happen because full employment was assumed. Never mind that, not only does involuntary unemployment happen, it is almost always present. Models tend to assume it away.

Another influential howler? Take wage theories. Typically, they’ll (well, those that are micro-economics based at any rate) claim that one is paid his marginal productivity. The reasoning is that, if this were not the case, you would go apply your trade to the competitor next door, who will of course be willing to pay you a little bit more as long as your wages are below your marginal productivity (or be shown the door if you produced less).

Right, this should have hurt your intelligence on so many levels that I guess I should apologize for typing this last sentence. I’m sure I could easily write 20 pages on why this reasoning is atrociously unrealistic. But let’s focus on the rather obvious one: why would the employer need to pay you what you produce if there are battalions of unemployed people, desperate to get something, anything, for a pittance? Ah, but that could not happen if you assume full employment, because then you’d need to outbid their current employer. Rather convenient that we can assume full employment then, isn’t it?

Again, developed countries tend to pass laws to prevent trade restrictions without helping those whose careers they destroy in so doing, and typically weaken the powers of unions on the ground that they restrict the magical microeconomic mechanisms that are supposed to lead us to the blissful state of full wages equilibrium –despite not having experienced full employment in decades.

3. Markets

So many people profess a faith in markets that they appear to be the major religion of the time. The idea is that people reveal their true preferences with their purchases, and that letting markets setting all prices without interference will therefore lead to a social optimum under some conditions (such as no player having significant market power, full information…).

OK, there too it’s immediately obvious that most situations do not look like those conditions are near being met. There is a whole literature about market failure, and I don’t pretend to cover that here.
Then it makes huge assumptions on the actors themselves, that behavioural studies (and behavioural economics) have shown to be highly bogus. That, too, is heavily studied, and I’ll encourage you to read much about it.
We may also mention the delicate problem of externalities. Who is to say that only the supplier and purchaser are concerned by the outcome of the transaction? This is of course well known, yet somehow usually pushed aside when market legislation is drafted. Still, let’s leave that behind for now.

I’d like to go to the very fundamental assumption: using the prices that actors are willing to pay in the transaction as a proxy for their desire, level of satisfaction… All the claims of social optimum need, to make any sort of sense, that all dollars have the same satisfaction value, and to anyone. It must be linear and undifferentiated.

Wow. I consider myself highly privileged, yet a glance to some press reports will inform me that there are a few people whose wealth is 60000 times greater than mine. If we are to believe this assumption of a linear proxy for satisfaction, I must conclude that they have 60000 times more enjoyment. How can they even sleep with so much excitement?

OK, maybe I take the assumption too far, and we should only look at the satisfaction from the transaction (although that weakening is enough to put to rest all claims of social optimum). That still doesn’t sound right. I am still a very careful spender, but saving 10€ is not quite as memorable now than in my childhood. I am now willing to pay a lot more for some things (a bike, a ticket to some concerts, a music book…), even though they will not bring as much joy as when I was much younger. Surely a major reason is that I did not have much to spend then.

Willingness to spend can make any limited sense as a proxy to enjoyment only if ability to spend is fairly equal. And we are moving away from it with great hurry. To take an extreme example, if only one person had pretty much all the money, well since no one could bid for any house, he would soon own the whole housing supply (without needing to pay much for it, since no one else would be able to bid at all). Yet clearly his 4th millionth house would not have as much value to him as to all the people he was able to outbid –who would have to sleep outdoors because they did not have enough spending power. As I said, not only is the assumption the model needs not met, it is less and less so. Yet the idea of unrestricted markets leading to the social optimum has been a main act of legislative changes in the past 35 years.

In all cases, not only are models relying on assumptions that are wildly false in today’s world being used, they are now deeply ingrained in the laws –including constitutional laws- of the developed world. The failure is not merely intellectual, it is institutional. And it so prevalent that few people even notice the outrageous assumptions being made.

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