Hayek on Scientistic Hubris

by Don Boudreaux on December 16, 2011

in Hayek, Hubris and humility, Scientism

Here’s a letter to the Wall Street Journal:

Burton Malkiel rightly applauds Emanuel Derman’s message, in the latter’s Models Behaving Badly, that the mathematical methods that are so successful in the physical sciences are typically useless – or even downright dangerous – in the social sciences (“Physics Envy,” Dec. 14).

F.A. Hayek early on warned social scientists not to succumb to this “physics envy” (which he called “scientism”).  To this day, Hayek’s reputation suffers undeserved contempt because too many economists fail to appreciate the wisdom of his warning that the pertinent phenomena dealt with by the social sciences are too numerous, changing, and complex for their detailed interconnections to be successfully described – and for their specific quantitative values to be successfully predicted through time – by mathematical models.

As Hayek explained in his Nobel lecture, here alluding specifically to post-WWII macroeconomic modeling: “It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error.  It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, ‘is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.’”

Sincerely,
Donald J. Boudreaux

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Daniel Kuehn December 16, 2011 at 7:42 am

Let’s be very clear here – Derman’s book is about quants on Wall Street which is a very different thing than the sort of modeling that Hayek was erroneously charging with scientism.

Quants on Wall Street are comparable to local weather forecasters in what they do. They are forecasting complex systems. That’s a fool’s errand. We’re probably good enough at that sort of thing to use the information to decide whether we take an umbrella with us or not. We are not good enough at it to justify using it to direct trillions of dollars over the long term.

Forecasting is very, very, very different from mathematically modeling and testing econometrically past data to assess certain theories about how the economy works and the sorts of mechanisms and relationship that drive the economy. One can do that – just as one can study what determines the weather – and still admit that you are unable to predict the future.

I don’t know why you and Russ are so intent on conflating these two very different practices. Russ does it a lot with the Romer-Bernstein numbers too, which is really two numbers: a multiplier estimate and a forecast.

Derman’s claim here is about forecasting. Hayek’s claim was about the whole modeling endeavor. Derman is right. Hayek was wrong. Derman does not offer proof in favor of Hayek’s proposition.

Methinks1776 December 16, 2011 at 8:03 am

We are not good enough at it to justify using it to direct trillions of dollars over the long term.

What do you mean? Specifically which models are you talking about? If you’re talking about forecasting the S&P 500, then I agree with you. But, only fools actually take that kind of forecasting seriously enough to trade on it.

The relationships between securities are much more easily quantified than human behaviour. Quantitative models are excellent at calculating these relationships. They are terrible at recognizing paradigm shifts – which is why most of us have automatic shut-offs built in. In other words, prudent users of quantitative financial models understand their limits.

Daniel Kuehn December 16, 2011 at 12:08 pm

Exactly. Relationships between securities is something we can do. Forecasting the path of securities – index or otherwise – is a different proposition entirely.

There’s a lot of confusion – on these pages particularly – between modeling something to understand a mechanism and forecasting a system. These “scientism” charges jumble the two together. We can get a good sense of how a complex system works without knowing where it will go.

re: “In other words, prudent users of quantitative financial models understand their limits.”

Precisely. The macroeconomic equivalent is that I pay a fair amount of attention to what forecasters think will happen with unemployment next month. That is valuable – if imperfect – information. I do not (as many people have done) rule the stimulus a failure on the basis of a three year forecast of unemployment. I wish more people would make this distinction which you do hear rather than just tossing around “scientism” charges.

Methinks1776 December 16, 2011 at 4:20 pm

Well, I don’t know who these “many people” that you’re referring to are. I think one reason the stimulus has been ruled a failure by the people who will bear its cost is not so much because of whatever three year unemployment forecasts are predicting but because it didn’t deliver on the promises. Remember “if we pass the stimulus plan, unemployment won’t go above 8%”?

Darren December 16, 2011 at 8:06 pm

Remember “if we pass the stimulus plan, unemployment won’t go above 8%”?</i?

Too many people seem to want an easy solution and a guarantee that it will work.

Methinks1776 December 16, 2011 at 8:31 pm

That’s what politicians sell them, often with the help of NYT columnists formerly known as economists.

Methinks1776 December 16, 2011 at 8:10 am

Forecasting is very, very, very different from mathematically modeling and testing econometrically past data to assess certain theories about how the economy works and the sorts of mechanisms and relationship that drive the economy.

That’s some crazy hairsplitting. You can’t forecast without back testing and you can’t guide policy without using those models to forecast.

Krishnan December 16, 2011 at 9:32 am

True – Writing/testing models JUST to explain what DID happen is fine and dandy – but at the core, useless. And yes, like forecasting the number of hurricanes – AFTER the fact. A model is useless unless it CAN predict – in fact, the purpose of examining past data to develop the models it to be able to predict what may happen in the future – The problem is that in the social sciences, we simply do not know all of the key variables involved and so we have been unable to develop predictive models – Hayek’s point is to remember that unlike physics (and other sciences) in economics/social sciences, we are foolish to imagine that we can capture all of the complexities of an economic/social system in some model/equations

Sam Grove December 16, 2011 at 11:59 am

The real world includes too much randomness to ever successfully predict what comes next, especially over the long term. The only way to get around that limitation is to exclude randomness and that’s a world we don’t want to live in.

vidyohs December 16, 2011 at 8:12 am

See my comment below, DK. The problem with people like you and the people you seem to admire so much is that all of you think you can do something that is impossible from the get-go. But, none of you can see that, because you believe that you can take the wisdom of the street regarding individuals and massage it into a science that will be accurate in predicting the collective.

When dealing with individuals who have free choice, there is no science. Therefore the moment you hear (follow my example) or read someone claiming any, even the teeeniest remotest hint, ability to predict human behavior using science……do what I do, dismiss them out of hand as charlatans and fools no matter how high sounding their dialog is. Knee jerk to think micro first, to see if it will work or can be done.

If it can’t be done at the micro, it can’t be done by trying to make it macro and predict it.

Lee Atwater December 16, 2011 at 8:33 am

vidyohs

jumper cables.

the foundation of capitalism is the forecast. no one would be in business unless they had some idea that people would come in the door and buy what you have to sell

Using observation, insight, and analysis of data is a key driver of other social sciences and should be of ecnomics.

if one cannot forecast, then we ought to turn to Marx, quickly

Hayek was really wrong about uses of science and math by other social sciences, where such is being done very successfully. Ever read Money Ball or seen the movie?

vidyohs December 16, 2011 at 9:01 am

Seems like you need to check who used those jumper cables on you.

The forecast you speak of is no more than anticipation of a hope. You can forecast all you want, but when dealing with human choice it is not a science nor can one make an accurate infallible prediction regarding human choice.

I can forecast that you think way too much of yourself, but I can’t predict that you will always be that foolish, because you have a choice in the matter.

Thank you very much.

Ubiquitous December 16, 2011 at 8:17 pm

. . . no one would be in business unless they had some idea that people would come in the door and buy what you have to sell

That’s called wishing, hoping, guessing, praying, presuming, assuming — all of it future-oriented, SUBJECTIVE, ex ante, human action. None of it has anything remotely to do with mathematical modeling or forecasting.

if one cannot forecast, then we ought to turn to Marx

False alternative. The choices are not “quantitative forecasting” or “Marxian mysticism.” There’s another choice: pattern prediction. By Austrian lights, that’s about the best economics can do.

Daniel Kuehn December 16, 2011 at 12:11 pm

re: “The problem with people like you and the people you seem to admire so much is that all of you think you can do something that is impossible from the get-go.”

Could you be more specific? What do you think I think we can do that is impossible? This comment you’re responding to is me saying precisely what you’re saying here: prediction of a system is different from understanding how a system works. We have very limited prediction possibilities for a complex system.

Living organisms and biological evolution are complex systems too, vidyohs. We can’t forecast what organisms will evolve in the future for the same reason we can’t forecast the economy far into the future. You wouldn’t say evolutionary biology isn’t a science, would you? You wouldn’t say that evolutionary biologists’ models are junk would you?

vidyohs December 16, 2011 at 6:44 pm

“re: “The problem with people like you and the people you seem to admire so much is that all of you think you can do something that is impossible from the get-go.”

Could I be more specific? Well yes I can. You and the people you seem to admire so much are all convinced that yes indeed you are smart enough to make collectivism/statism work. You think it doesn’t come through in your posts and comments, but you’re as wrong today as you were when you appeared here those long days ago. If you were as smart as you believe yourself to be, you’d give it up on socialism, it fails, it failed yesterday, it fails today, and it will fail in the future for the very reason no one can successfully predict and plan for 7 billion individuals, no matter that those 7 billion are broken down into smaller numbers contained in nation states. Even a small group of people like the Pilgrims, with religious fervor and faith in planning, almost killed themselves on it.

“Living organisms and biological evolution are complex systems too, vidyohs. We can’t forecast what organisms will evolve in the future for the same reason we can’t forecast the economy far into the future. You wouldn’t say evolutionary biology isn’t a science, would you? You wouldn’t say that evolutionary biologists’ models are junk would you?”

That is disingenuous, tortured, and twisting.

Predicting and forecasting is about the future, not the past.

Evolutionary biology is a study of past evolution, not a study of future evolution as future evolution is…….well in the future and can’t be studied. Which means I would not and did not say anything about any model of an evolutionary biologist. Why, because it is meaningless, irrelevant to this discussion which is about predicting or forecasting, since you used the weather as your example. (No difference between being a weather forecaster or a weather predictor, is there?)

But, I do admire the attempted disingenuous sidetrack into evolutionary biology as a way of changing the focus.

GAAPrulesIFRSdrools December 16, 2011 at 11:41 pm

its a diagnosis of exclusion.

Ubiquitous December 17, 2011 at 5:30 am

You wouldn’t say evolutionary biology isn’t a science, would you?

Yes I would. As Karl Popper once asserted: Darwinian evolutionary biology is not so much a science as it is a “metaphysical research programme” (his words”). I agree.

You wouldn’t say that evolutionary biologists’ models are junk would you?

Yes I would. But it doesn’t matter what I would say about it. The point is, other scientists involved in “hard” quantitative sciences such as physics, chemistry, and engineering have often commented on the junk-quality of the models in Darwinian evolutionary biology: the sweeping generalizations, the breezy starting assumptions, the unprovable assertions, the unfalsifiable theories, the hand-waving arguments (Good grief! That sounds like Keynesianism!); the models that cannot do what scientific models are supposed to do: they cannot start with present data and the causal laws or forces assumed as part of their models and predict a future state of affairs (e.g., a future species) with any accuracy or precision, nor can they start with present data and the causal laws or forces assumed as part of their models and retrodict to a past state of affairs (e.g., past species).

If something calling itself a science cannot predict the future or retrodict the past, one can hardly call it a science. Perhaps it’s something else — like a metaphysical research programme.

Lee Atwater December 16, 2011 at 8:26 am

Dan

You got some nice coverage by Brad Delong

Why do you bother with Russ and Don?

Congrats.

Daniel Kuehn December 16, 2011 at 12:11 pm

Lots of people read Russ and Don.

Ubiquitous December 16, 2011 at 8:20 pm

You got some nice coverage by Brad Delong

Backhanded compliment; Delong’s a moron.

Why do you bother with Russ and Don?

For that matter, why do you bother with them?

GAAPrulesIFRSdrools December 16, 2011 at 11:42 pm

Is it bother with, or just bother?

Ubiquitous December 17, 2011 at 4:55 am

Is it bother with, or just bother?

An excellent question. I would say that it’s “bother with Russ and Don” and “bother the rest of us.”

Tor Munkov December 16, 2011 at 8:52 am

What was Beethoven’s Ninth Symphony about? Your very claim that a book is “about” one thing is a false monomial assertion.
This is not exactly scientism, but rather mathematicism, scientisms ugly sister-wife.
There are only 10 types of people, those who understand the limited applicability of binary computation and those who don’t.
Which of the 10 do you want to be?

Daniel Kuehn December 16, 2011 at 12:12 pm

I understood your second paragraph fine. It’s your first paragraph that’s confusing me.

Tor Munkov December 16, 2011 at 4:30 pm

I enjoy reading your writing quite a bit, though I hope you fail in your current endeavours as I understand them.

You arrogate as real a hypothetical ordering system not fully developed nor asserted and seem to demonstrate that x, the thing you dislike, is something that can be safely excluded or relegated to some other discussion. Like astrology and tetrathys, your musings seem reasonable and applicable and one is lulled into accepting the computed product of your a priori variables as correct.
__
Here are two examples.

It takes hearts and guts to play for the New Orleans Saints. You won’t make their roster with nothing more than the highest available moneyball/sabremetric score. You have to have winning in your blood and the singularly focused soul of a champion.

History has shown that Ron Paul is not a candidate running for president. It is patently obvious he is a serial campaigner for the Koch brothers, Israel, and the usual Corporate Money Lenders who are subverting our sacred electoral process. Unless Paul adopts a more mainstream campaign with some chance of winning elections like Gingrich or Romney, he can be dismissed as a demagoguing shill for the Paleolithic Republican Booster Club.
__

Assuming one is of low enough means to not fall into the minority coerced class, all you say is quite beguiling and inspiring, a win for many a lose for few. If one only develops a blind spot to the fatal corrupting variable of state force you vainly bury in your forecasted harmonic bliss, you will be handily able to obscure the reality that everything you are advocating is really a lose lose, and get one over on the gullible suffering masses. The win is for the state workers and a few cronies, the lose if for both the rich and poor populace.

Ubiquitous December 16, 2011 at 9:09 pm

Assuming one is of low enough means to not fall into the minority coerced class, all you say is quite beguiling and inspiring, a win for many a lose for few. If one only develops a blind spot to the fatal corrupting variable of state force you vainly bury in your forecasted harmonic bliss. . .

Can anyone say “word salad”?

Tor Munkov December 17, 2011 at 8:28 am

@Ubiquitous. Yes I can say that. Can you say pseudonym tsunami?

Jon Murphy December 16, 2011 at 8:58 am

I kinda have to agree with Dan Kuehn here. Forecasting is different from modeling. Sure, forecasting uses models, but there’s a lot more than just that.

With forecasting, you factor in experience, expectations, models, and half a million other variables to arrive at a conclusion.

Forecasts also have a range. No forecast says “growth will be this.” Forecasts say “growth is expected to be between X and Y.”

Both models and forecasts have their uses. But neither are oracles.

Greg Webb December 16, 2011 at 9:34 am

Jon, I agree with you that forecasting has its uses. They are limited and should always be considered with caution because they are often wrong. See Paul Krugman’s famous forecast on inflation.

By adding the element of mathematics, prognosticators give their predictions the veil of science and precision that is associated with mathematics. But, the reality is that forecasters are often no better than there famous predecessors – fortune tellers.

And, forecasters often prevaricate to support their preconceived notions as to what is going to happen. For there are three kinds of liars: 1. Liars, 2. Damn Liars, and 3. Statisticians.

Jon Murphy December 16, 2011 at 11:02 am

I agree fully, Greg. One must always be cautious forecasting. But I think Dan’s original point still stands (Except for Dermin is Right, Hayek is Wrong, bit, but that’s more an argument of semantics).

Daniel Kuehn December 16, 2011 at 12:13 pm

To be clear, Paul Krugman has never provided an inflation forecast that I’m aware of.

What he’s said is that given the macroeconomic situation, he does not expect strong inflation pressures.

I think you all are using the word “forecast” too loosey goosey here.

Mesa Econoguy December 16, 2011 at 8:35 pm

Uh, Danny, here it is:

http://old.nationalreview.com/nrof_luskin/kts200406170833.asp

Perhaps you are confused that he was so painfully incorrect, which he was/is, and was in fact fired for the extent of his incorrectness.

But it is most definitely a forecast.

Mesa Econoguy December 16, 2011 at 8:36 pm

As we know, Kruggy is often wrong

http://johnbtaylorsblog.blogspot.com/2011/12/krugman-is-wrong.html

especially when he pretends to have knowledge of his subject matter.

Mesa Econoguy December 16, 2011 at 8:37 pm

PS, here is Kruggy baby calling Socialist Insecurity a Ponzi scheme:

http://www.bostonreview.net/BR21.6/krugmann.html

LOL, wonder if he remembers that one.

khodge December 16, 2011 at 11:14 am

I don’t think that Dan makes a compelling argument that quants on Wall Street are significantly different from econometrics or the modeling done in macroeconomics. There cannot be many systems that are more complex than adding together billions of supply-demand curves.

Sam Grove December 16, 2011 at 12:04 pm

A problem with economic forecasting is that some people get the idea “what if we do this?”. Then they introduce a new variable to which people react in sometimes unpredicted ways.

Damn it, people are supposed to be spending and hiring now.

Invisible Backhand December 16, 2011 at 10:58 am

I don’t know why you and Russ are so intent on conflating these two very different practices.

I do.

Also, Don, you forgot to add:

Professor of Economics
George Mason University
Fairvax, VA 22030

Problem?

Emily Latella December 16, 2011 at 12:30 pm

@DK

You’ve missed the point. Yes, there’s a difference between modeling and forecasting. There’s also a difference between projectioning and forecasting.

Despite the differences, they all rely on assuming that abstractions of human behavior can be represented by equations in the same way that the is done with the physical sciences.

As an aside, the record for macro-level forecasters is far worse than that of quants. It would be hilarous if not it weren’t utterly ridicuolus and destructive to see the original forecasts of cost estimates for Medicare that were made at the inception of the program-as I recall in the hundreds of millions of dollars decades after the creation.

Churchill once quipped something about the greatest discoveries being thing rediscovered after being forgotten. Epistimology would be such a great discovery.

Emily Latella December 16, 2011 at 12:31 pm

Errata:

projecting and forecasting.

GAAPrulesIFRSdrools December 16, 2011 at 12:33 pm

Pseudonyms behaving badly. Hah Hah.

Daniel Kuehn December 16, 2011 at 12:42 pm

re: “As an aside, the record for macro-level forecasters is far worse than that of quants. It would be hilarous if not it weren’t utterly ridicuolus and destructive to see the original forecasts of cost estimates for Medicare that were made at the inception of the program-as I recall in the hundreds of millions of dollars decades after the creation.”

So this paragraph, to me, is as meaningless as laughing at meteorologists in the 60s (when Medicare was put together) because they inaccurately predicted what the weather would be like on December 16th, 2011.

If you want to agree with me that you just can’t do that, then I’m happy to have you agree with me. But then, I don’t know why you lead with “you’ve missed the point”. That was my point.

It’s not a matter of describing something in an equation. Its no more problematic to describe something with an equation than it is to describe it with a sentence. Both are imperfect simplifications that capture insights about behavior. Equations aren’t the issue.

The issue is going from thinking “I can parsimoniously say something useful about how the variable X works” to thinking “I can tell you what path X will take in the future”. If the system incorporating X is complex, you really can’t do the second one – although you’re very likely to have important insights about the first one.

- Understanding the relationship between government spending and the unemployment in a given situation is hard, but achievable. Predicting how unemployment will act in the future given all the complicated forces affecting it is not achievable.

- Understanding the relationship between supply and demand in any given market is hard, but achievable. Predicting how demand and supply will change in the future given all the complicated forces affecting them is not achievable.

The issue of equations has very little to do with it. The problem is the complexity of the system. Mechanical systems can be forecast far into the future. Complexity restricts the horizon that you can usefully forecast something.

GAAPrulesIFRSdrools December 16, 2011 at 2:26 pm

So this paragraph, to me, is as meaningless as laughing at meteorologists in the 60s (when Medicare was put together) because they inaccurately predicted what the weather would be like on December 16th, 2011.”

Except they didn’t do that-but medicare actuaries did. It would’ve been obvious to everybody that people who bat 1 out of 3 after five days, to make such an attempt were engaging in baseless conjecture. On the other hand, confident government actuaries made even more baseless estimates, with less information.

- Understanding the relationship between government spending and the unemployment in a given situation is hard, but achievable.

Really what is it? Does it depend on the magnitude or the form? Come, tell us (and do it without mathematical relationships because equations aren’t the issue)

We’re told a couple years ago that government spending would keep unemployment under 8%, but hmmm its 8.6% now and has been as high as 9.1%. So was Romer & co malsfeasant in making that claim given the complexity?

GAAPrulesIFRSdrools December 16, 2011 at 2:27 pm

One of thing. What “mechanical system” are you referring to?

I Miss Nixon December 17, 2011 at 3:36 pm

Brad Delong just posted more compliments for you

Why do you continue, here

What not just admit the whole Hayekian thing is wrong, wrong, wrong and move on?

Troy Camplin December 17, 2011 at 4:16 pm

No Hayek was right, given the models available at the time. We have better computational models today, but even so, we have to be careful with them, because they can be used to “prove” things that are simply not true. If you have the wrong model of human nature, for example. And that’s where many economists go wrong.

The math, because of computers, is catching up with economics — and consistently proving Austrian economics to have right far more often than any other school of economics. The math and models of Hayek’s time, when he was writing about scientism, etc., was absolutely correct. The models were from the physical sciences, and gave us consistently wrong answers. To the extent that most mainstream economists continue to use such models, they continue to be wrong.

But if you look at the self-organization, complexity, etc. computational models — especially those that put in a very high number of variables similar to those humans have — they consistently come up with Austrian answers. Certainly when Krugman is using his models, for example, which involve complex, self-organizing computational modelling, he says little an Austrian would disagree with. It is when he gets outside his expertise that he adopts nonsense and says idiotic things, and attacks the only school of thought which actually agrees with him when he does scientific rather than demagogic economics.

Math is simplifying, and is necessarily so. Language can either be simplifying, or complexifying. In dealing with complex processes, you need the language that comes closest to matching it. Math is not that language, and never will be. Computational models do better, but they too are simplifying. They can “isolate” some things, but you still need to compare them to the real world.

vidyohs December 16, 2011 at 7:58 am

Obvious. Inanimate objects, including gases, do not have choices. Therefore, inanimate objects are rarely, if ever, seen to change; and if seen to change, will typically do so in accordance with past observations.

Economics, market activity, trade, etc. et. al., are constructs of humans, who do have choices, and rarely, if ever, are seen to be in direct accords with their immediate neighbor or fellow humans.

Physical science and any “science” involving human choice, must be different.

Greg G December 16, 2011 at 11:31 am

vidyohs

You think you have free will? Your behavior is fully determined. Try not saying “looney lefty” or “broken brain” for a few months.

I predict you will fail miserably at that. This prediction has as much certainty as is available to any of the real or implied sciences.

Greg Webb December 16, 2011 at 11:45 am

LOL! Greg Government, Cafe Hayek’s self-appointed hall monitor and censor, is at it again! What words will he ban next?

Greg G December 16, 2011 at 11:53 am

LOL

Max Power December 16, 2011 at 8:06 am

“One can do that – just as one can study what determines the weather – and still admit that you are unable to predict the future.”

Predictions are what matter to real scientists. If all that you do is look at old data and try to construct some coherent sounding story then you’re a historian, nothing more.

The hierarchy is: real science, social science, humanities, government-paid apologist for Leviathan (you).

Lee Atwater December 16, 2011 at 8:42 am

jumper cables

You are here leaving a comment, claiming to be a Hayekian, and yet you, and everyone else here is a closet Keynesian.

You know, but will not admit, that we cannot cut Gov’t deficit spending at present because the economy would collapse, due to a lack of demand, just as Keynes predicated.

There is no path to growth through austerity or liquidation. See Ireland, Great Britain, etc.

Nor is their any heirarchy. The Bard wrote as much, if not more truth, than Einstein. See Higgs boson

khodge December 16, 2011 at 11:28 am

I haven’t seen any evidence that everyone here believes that we cannot cut government deficit spending. There are political reasons why it cannot be done but the more compelling evidence presented by Russ and Don is that government spending is more of a problem than a solution and that we can and should cut it.

Austerity and liquidation may well have helped Japan whereas Ireland and Great Britain prove only that there is a world-wide recession.

Jon Murphy December 16, 2011 at 11:40 am

It is also important to note that What GB and Ireland and Japan are doing is not austerity. Cutting the rate of spending is still spending. For true austerity to occur, the rate of spending must be below the income.

Additionally, Keynes said that it is during a time of economic recovery and growth (example, NOW), that governments should cut back on spending. There is no evidence in the US economy for a lack of demand: retail sales are above the pre-recession level and growing faster. Auto production and retail sales are increasing, US Industrial Production is chugging along, the private sector is adding jobs hand-over-fist (over a million jobs since June!), construction is slowly beginning to grow again, US manufacturers cannot hire people fast enough, the utilization rate is at the highest level since July 2008 and growing. Now is exactly the time, according to Keynes, to launch austerity.

Sam Grove December 16, 2011 at 12:06 pm

I think government deficit spending should be eliminated and I disagree with you that the economy will collapse because of that.

Tor Munkov December 16, 2011 at 4:54 pm

Me too. You can’t collapse something that is already escalatingly collapsing since 1835 under Andrew Jackson.
Once every dollar is spent and returned to the Fed and no more are issued, you can start anew.
Federal reserve notes are pure debt. Fractional Reserve Banking is a self-perpetuating treadmill wherein each dollar received from the Fed undergoes a financial mitosis into about 9 dollars.
Savers are lambs to the slaughter.

kyle8 December 16, 2011 at 5:40 pm

Air freshener

There is no way out of this mess we are in EXCEPT to cut government spending. As long as the deficits continue to rise and our level of debt rises there will be less and less desire for private investment capital to invest in any enterprise within our borders.

Troy Camplin December 17, 2011 at 4:18 pm

your hierarchy implies that government-paid apologists are more complex than the humanities. That is nonsense. They are folk economists and atavists of the worst kind. They are definitely below the hard sciences in complexity.

In order, from simplicity to complexity: math, physics, chemistry, biology, psychology, the social sciences (including economics), the humanities (philosophy, the arts).

Lee Atwater December 16, 2011 at 8:22 am

As I always say, “Jumper Cables.” The boy must have used jumper cables in his youth.

Hayek had less of an idea what he was talking about here than elsewhere.

The true wisdom on the Scientific Method came from Mark Twain. who observed that “Lies, damned lies, and statistics” is a phrase describing the persuasive power of numbers, particularly the use of statistics to bolster weak arguments.

Hayekian economics is dominated by Lies, damned lies, and statistics, the latter being all the correlations which are neither predictive nor which show causation.

Yesterday, this blog attacked Stiglitz for using the scientic method, of which the first step is simply observation. Stiglitz has made the very common sense observation—far beyond the power of Don or Russ—that we have poured a lot of water (stimulus) on the fire (Lesser Depression) and we still have smoke.

This can only mean one thing: THE ECONOMY WAS IN FAR WORSE SHAPE (AND WORKS DIFFERENTLY0 THAN WE SUPPOSE. So what has he done. He has formed a hypothesis (that depressions can be caused by too rapid changes in productivity, which he illustrates by talking about farmers who incomes collapsed due to productivity gains before the Great Depression). He reasons that they could not move to Mfg. because their collapse in income collapsed the demand for mfg.

Now rather than respect him, his skills, and insights, this blog immediately attacked him, misusing science exactly as Hayek warned against. There were a bunch of people who demanded to see his data and you could tell that, regardless of what that data said that wouldn’t accept Stiglitz’s ideas.

The episode reminds me of the Higgs boson. When Higgs proposed it and the Higgs field, he could not even get his papers published.

Stiglitz is no fool. He wrote his piece for Vanity Fair because he realizes that there is no “science” now in economics. John Kay, at FT, wrote a great piece about this in the summer, explaining that the Queen was right.

Using models that cannot tell you that we are in a bubble is not science.

Don and Russ are the two worst sinners here. Ask them, if it was proved that Hayek was wrong today, they would admit that they wouldn’t change a thing. They are invested in Hayek.

Methinks1776 December 16, 2011 at 8:30 am

This can only mean one thing:

This is the point at which one understands that everything that will follow is bullshit.

In a complex system, the answer can never be only one thing.

Lee Atwater December 16, 2011 at 8:49 am

Wrong:

E=MC2

See Higgs boson

or

get yourself a copy of A New Kind of Science Stephen Wolfram, published in 2002

Wolfram gives you 1400 pages showing that you are wrong

The proposition offered is either true or false.

Dances with Wolves December 16, 2011 at 9:22 am

Irritable Bowel, another new name?

Methinks1776 December 16, 2011 at 10:51 am

Luzha.

Sam Grove December 16, 2011 at 12:10 pm

Ah, you jumped from the social sciences to the physical sciences to support your assertion.

Changing the context wherein the right answer for one is the wrong answer in the other and vice versa.

Could it be you missed the point?

Ubiquitous December 17, 2011 at 5:09 am

Wrong: E=MC2

I don’t see any complexity, dipschultz. There are only two variables: “M” and “E.”

“C” is a constant.

Methinks1776 is right. E=MC^2 is not complex; it’s simple, but profound.

You confused “profundity” with “complexity.”

kyle8 December 16, 2011 at 5:43 pm

chainsaw

Or, (perhaps just perhaps) you and Stiglitz are both wrong. SInce I see no evidence in your favor I will proceed with that assumption, But I will keep an open mind.

James A. Johnson December 16, 2011 at 8:52 pm

Hey, I was just trying to give free housing away to the dying middle class.

My models all said the same thing: give more government and private money to me/Henry Cisneros/Andy Cuomo/Angelo Mozilo, so I can create a bubble and destroy much of the modern financial system in the name of “equality.”

And so I can have enormous power, influence, multiple mansions, and expunge my ‘84 Mondale campaign management failure.

Now how is that not an admirable goal?

nailheadtom December 16, 2011 at 9:32 am

Those enamored of historical analysis and modeling for forecasting purposes can always prove their theories at the betting windows of horse racing tracks. Let us know how you do.

jjoxman December 16, 2011 at 11:34 am

Wow, the quality of comments just gets worse and worse around here. Now people just randomly pop up yelling nonsensical phrases at each other? “Jumper cables!” Wth? You poor commentators know who you are, and I want you to realize the negative spillover of your comments. Many new people with potentially good comments post here quite often. However, because there are so many poor commentators, I have gotten to the point where I seek out those specific few people who have a reputation for good, or at least thoughtful, comments. Even Daniel Kuehn, who often drives me nuts, but is a thoughtful fellow :) . The point is, he is worth reading, as is Methinks, vidyohs, IndianaJim, and a few others. But those without a reputation who may be posting good comments are passed over by me (and maybe others) with little time to sort the wheat from the chaff. So with your fellow posters in mind, cut down on the chaff, bring the ad hominems to heel, and think before you post. Being a prick doesn’t buy you anything but it does define you as being a prick.

Methinks1776 December 16, 2011 at 11:42 am

Thannks, JJoxman. I think your comment confirms to the trolls that they are achieving their desired effect. Destroying the blog is the goal.

Never mind them. I’m glad you’re here. Since DK brought up financial modeling and you’re a professor of finance, I was hoping you’d stop by and say something about it.

jjoxman December 16, 2011 at 11:45 am

See below, but I think I have more to say.

I think I need to post more – can’t let the trolls win.

Actually, the trollish behavior is no different than what I’ve experienced in a live talk where people attempt to silence me or others by ‘shouting them down.’ It is thoughtless behavior and contemptible, but we must retain our calm and work against it.

Jon Murphy December 16, 2011 at 11:52 am

Really, the best thing we can do is not engage them. We are all guilty of it (myself the most). Even when they make a claim that is factually wrong, the best thing you can do is not hit the reply button. It takes will power.

Michael December 16, 2011 at 11:56 am

+1

Methinks1776 December 16, 2011 at 12:16 pm

Yes. You need to post more. Much more. That would be lovely.

Just after I posted my reply, I saw the post below. But, is this what the Quants that DK was talking about are modelling? We mainly use them to model derivatives, relationships for statistical arbitrage, creation of derivatives and for risk management, don’t we? In other words, for things that have actual quantitative relationships.

The price of a future is always going to be cost plus carry. The price of an options is always going to be determined by the inputs. These, unlike changing tastes, preferences and expectations are easily quantifiable.

jjoxman December 16, 2011 at 12:18 pm

Ya, I posted more about modeling in asset pricing. My first post I had my corporate finance hat on, which wasn’t clear.

Methinks1776 December 16, 2011 at 12:45 pm

In the middle of the day, I jump in and out during dead moments, which means that I have a tendency to finish a comment long after I’ve started it. That doesn’t always work so well. This would be an example :)

I Miss Nixon December 16, 2011 at 3:55 pm

jjoxman

truth, like art, is in the eye of the beholder.

you wouldn’t have so many trolls except that you, like everyone else on the right, tolerate the most outrageous of comments, as long as it is from a right wing wacko

For example, you tolerate comments that attack Lincoln and FDR and Truman, to say nothing of Keynes.

You have posters who persistently write in terms of culling the heard and many other racist comments.

You had someone claim that Lee Atwater, a complete cull, who got his start in politics by deriding a Democrat who was treated for depression as a child with electronic shock treatment as being the product of “jumper cables.”

Don periodically praises the racist Mencken.

In sum, you want to stop trolling, then stop the right wing nuts.

For example, I am a true Keynesian, who well understands that the “bluff” of printing money cannot go on forever. We have, hopefully, enough strength to start toward cutting our borrowing. However, a condition to doing such will obviously be silencing the outrageous rhetoric and conduct of the right.

IOW, if you want a blog, you best self-censor your own trolls first.

kyle8 December 16, 2011 at 5:47 pm

What a load of self righteous hogwash. Hey, BTW we have the biggest debt that mankind has ever know right now, when will it be time to cut back a little?

Methinks1776 December 16, 2011 at 5:49 pm

Kyle, it’s Luzha. What do you expect?

vidyohs December 16, 2011 at 5:56 pm

And there you have it. It is all the fault of the right wing. Your looney lefties can passionately believe in the right to stick your collective hands in my pocket, and that is not an act of evil; but, by God, when I slap those hands to knock them out of my pocket, I am responsible for the violence.

Your looney lefties can denigrate in all manners of foul language any idea that opposes collectivism and other scriptures of the socialist church; but when a right winger slaps you back with the same style of language, it is the right winger that is responsible for the disintergration of the rhetoric.

Have no wonder why I tell you that you and your crap make me sick.

I Miss Nixon December 16, 2011 at 8:50 pm

kyle8 and vidyohs are just the tip of the right wings trolls you tolerant.

never have either posted anything that contributes to anything. For example, I specifically wrote that, “We have, hopefully, enough strength to start toward cutting our borrowing,” and all we get is the “the biggest debt that mankind has ever know right now,” when we all know we had much greater debt at the end of WWII.

vidyohs is all about his pockets.

sorry vidyohs, but I happen to believe we ought to tap into everyone’s pockets to pay for the two wars, just conducted in everyone’s names, because of our collective moral responsibility. IOW, I want to raise your taxes (and mine) to pay down debt.

jjoxman December 16, 2011 at 9:41 pm

Well, you start from the wrong premise. I’m not on the ‘right’ and I reject the simplistic bifurcation of left v. right. In point of fact, I’m an anarcho-Catholic, which last I checked is some kind of super hero.

I’ll challenge anyone’s B.S., no matter their political leanings.

Here’s one for you. I believe in state’s rights and annulment, but so did John C. Calhoun. I don’t care – if the idea is sound, it’s sound.

Greg G December 16, 2011 at 9:55 pm

Wow. Anarcho-Catholic. That is a label I have not heard before. Just when things start to look predictable you shake things up. At least for a while you have had a positive effect on the level of conversation here.

Thanks for that jjoxxman.

Troll Watch December 16, 2011 at 10:43 pm

Kyle8,
You’re a ridiculous right-wing hick and troll. Fall into the bouillabaisse next time.

Lee Atwater December 17, 2011 at 8:19 am

jjoxman:

Here’s one for you. I believe in state’s rights and annulment, but so did John C. Calhoun. I don’t care – if the idea is sound, it’s sound.

so you are a pro-slavery racist.

we already knew that, troll

Greg G December 16, 2011 at 11:50 am

Good point jjoxman. We never see ad hominems from Methinks or vidyohs.

Jon Murphy December 16, 2011 at 12:10 pm

I think the final sentences were directed at all of us. Hell, I’m not going to lie, I’ve done ad hominem attacks before. It’s a natural, visceral reaction (especially with me. I can be…passionate about things I find morally objectionable). We all need to clean up our acts. You, me, Greg Webb, Methinks, Vidyohs, every one. We are all (presumably) adults here. But we aren’t acting like it, and I am the least of all to lecture.

jjoxman December 16, 2011 at 12:18 pm

Jon Murphy has it right.

We all need to act like adults.

Randy December 16, 2011 at 2:22 pm

Act like an adult? Seriously? I mean, if this isn’t escapism I don’t know what is. If I wanted to be published I’d send a paper to a journal. This is monday night football economics – where a bit of trash talk is just fine, thank you. The trick is just to not take it personally – and to give better than you get.

Jon Murphy December 16, 2011 at 2:35 pm

I get you, Randy, but it’s a matter of conduct. To keep with the football analogy, there is a difference between saying “You don’t like Suh because he’s a dirty player,” and “You don’t like Suh because you’re a racist.”

jjoxman December 16, 2011 at 2:45 pm

Ya, Randy, seriously. You want to be heard and taken seriously or not?

There are many venues for discussion and changing minds. This is one of them. I would argue a better one than the journals for reaching a non-academic audience.

“The trick is just to not take it personally – and to give better than you get.”

What is this, the Chicago way? He puts one of your guys in the hospital, you put one of his in the morgue?

Randy December 16, 2011 at 3:35 pm

I do know where you’re coming from guys, and I have learned much here – from the owners and the comments. But there are many econ blogs out there that are nowhere near as fun as this one. Personally, the line for me is personal insults – which I try to avoid… mostly. But insulting ideas I have no problem with.

Jon Murphy December 16, 2011 at 3:41 pm

“Personally, the line for me is personal insults – which I try to avoid… mostly. But insulting ideas I have no problem with.”

I can get behind that.

jjoxman December 16, 2011 at 7:44 pm

Randy,

You make a good point. I’ll jump down off my high horse. Now I gotta go talk a little smack.

vidyohs December 16, 2011 at 6:03 pm

Frankly Greg G., your dialog here and your persistent trolling is an ad hominem, the idea that you think you can consistently offer up that line of socialist crap and each time we are to think it is fresh because it comes from you, that is insulting to us all.

Greg G December 16, 2011 at 6:11 pm

vidyohs

I did not say, and did not ever expect, that you would view anything I had to offer as fresh. I am interested to know exactly what it is I said that you think is socialist?

Greg G December 17, 2011 at 7:51 am

jjoxman

It is possible you may not have been keeping up with vidyohs recent work. Enjoy:

vidyohs December 14, 2011 at 6:47 pm
@GiT
I don’t give a shit who you want to help or how much of your own money and effort you use to do it. Yea! Go for it you dumb fuck. What you are too stupid to see is that I will fight you to the death to keep you from using my efforts and my money to do it.

And, Kyle8 did a good job as well on telling you just how stupid you sound. And the reason you sound that way is because you are that way.

But, I’ll add to it by again pointing out to you, that those you save will only turn around and do it again, because they know you’ll save them again. So waste your life helping shitheads who won’t help themselves, just stay the hell out of the lives of those who are smarter than you.

vidyohs December 17, 2011 at 10:33 am

LOL! Good prose, Greg G. Glad to see you treasure it enough to save it.

Context, dear boy, is everything, and the context merits the prose, thank you very much.

It has long passed the time in America for people who want to be left alone to speak their minds emphatically and plainly to those idiot savants of the left who want only to shackle us. I for one decided long ago that I was going to take it to the looney left in exactly the same format they have been giving it to the right for so long. I tried reason and facts, only to see my opponent slip away into feelings and denigration. No more.

Greg G December 18, 2011 at 7:51 am

vidyohs

I see you are not up to the challenge of citing anything I have said that is socialist. Imagine my surprise. And yet you tirelessly quote muirgeo.

Just keep saying “broken brain looney lefty.” That is a level of argument that you are competent to maintain. Throw in some “dumb fuck” and “shithead” as seen above when you need to change it up a little.

g-dub December 19, 2011 at 9:51 pm

I tried reason and facts, only to see my opponent slip away into feelings and denigration.

Yah. I tried for years. Ultimately I determined “progressives” are dishonest and close-minded. These days I don’t take “it” seriously, and it shows.

An open-minded, inquistive, and intelligent progressive is one who won’t be a progressive for long.

jjoxman December 16, 2011 at 11:43 am

On the topic of modeling v. forecasting, I will speak from the financial economics point of view.

When we develop a model of past behavior, we are doing at least one of two things. The first is to develop a model that can predict future behavior. When we do this task, we always do ‘out of sample’ testing to determine the fit of the model. Our view, and my impression is this is the general view, is that if a model designed to predict behavior performs poorly in out of sample tests (i.e. forecasting) then the model is poor and should be discarded.

The other thing we might be doing is ascertaining the effect of some event on behavior of investors and/or corporations. Like the 2003 dividend/capital gains tax reconciliation, or SOX (2002). These also can have predictive testing elements, but it is not the goal here. The goal is to answer the question: did the dividend tax reduction of 2003 cause a change in dividend policy (btw, yes it did; dividends went up)?

Anyway, the Lucas critique was largely a Hayekian critique of modeling aggregate human behavior without micro foundations. This is the current research program in macro (I mean modeling macro phenomena with micro foundations) and it likely has a long way to go. We can also argue whether or not factor loadings remain stable, and those kinds of model restrictions etc. We can argue that mathematical (really statistical) modeling of this sort has limited usefulness. But, and this is my response to Daniel, to said “Hayek was wrong” is not helpful. If he was wrong, why did Minnesota/Rochester style macro become the norm? Unless I’m unclear on what you think Hayek was wrong about. If so, please to clarify. Gracias.

Daniel Kuehn December 16, 2011 at 12:18 pm

Hayek is wrong to dismiss it as scientism.

I think Don and Russ would dismiss a lot of the Minnesota/Rochester types as guilty of scientism. I think Hayek might too. Just look at Peter Boettke’s response to the Sargent and Sims Nobel – he thinks they’re part of the problem.

I think you are being far too generous here to Hayek by associating him that closely with what’s grown out of the Lucas Critique.

jjoxman December 16, 2011 at 12:27 pm

Okay, then we do disagree on the Hayek issue, and that’s fine. We can move forward amicably.

I agree with paragraph 2. I’m probably a lot more sympathetic to Minnesota/Rochester than they are, but that’s due to my education and current position – surrounded by thoughtful people from that pedigree!

But I would like to make the point that I do not think MN style macro has really come to terms with Austrian points about (a) capital structure and production and (b) knowledge. I’ve been following the discussion at Coordination Problem, so I think I know your thoughts on (b). We don’t need to hash it out here.

Maybe I am being too generous to Hayek – it’s like that with our heroes, isn’t it? But Lucas did attribute much of his thinking on the issue to Hayek, at least as the source of his thoughts, and the MN/Roch boys owe a lot to the Lucas critique.

Daniel Kuehn December 16, 2011 at 12:28 pm

Also -
Financial economics – I’m guessing I don’t have experience with it – is somewhat different than other economic modeling and econometric work.

I do a lot of work with empirical labor economics (well, I did before starting school – and will again). The modeling we do to understand the labor market often simply consists of determining different elasticities, and then I do a lot of work in particular with high skill labor markets and looking at the adjustment process in those markets (which is not immediate).

This is the sort of thing a lot of economists do – look at portions of the economy to understand how they work better.

In macro policy discussions it’s the multiplier you are estimating – and that in and of itself is hard enough to do. When you collect these insights they help inform what models of the economy make the most sense.

So I’m working on two book chapters right now on the engineering labor market, and I’m doing a lot with the behavior of that market over the past thirty years. I have a pretty good grasp of how it works. But if you were to ask me “what will engineering employment and wage trends be like over the next twenty years” I could probably give you intelligent speculation, but there’s no way to “test out of sample” the sort of empirical work I’ve been doing on this market. Lots of things could influence that market over the next twenty years. And some people do try to forecast these STEM labor markets – I don’t take any of that work very seriously, and I think most people working on these issues are skeptical as well.

So – maybe financial economics works differently. But my experience is there’s a lot of “modeling” that goes on that has very little do to with predicting the actual path of a variable.

Again – think of biology something I think we all agree is a science. We know a lot about primate behavior. We have a lot of data on it, and we’ve modeled it and come to conclusions about primate behavior. That doesn’t mean you can walk up to Jane Goodall and ask “who among your group of primates will still be a live five years from now, and what will they be doing on December 16, 2013?”. There’s a big difference between having a good model for understanding something and being able to predict something. Most of our models are conditional models. Prediction of the sort we’re talking about is always unconditional.

Anyway – I raise the Jane Goodall/primate issue because if you accept that you should be able to accept what I’m saying about economics. After all, economics is just the study of the social behavior of highly intelligent apes.

jjoxman December 16, 2011 at 1:19 pm

Daniel,

I can appreciate a lot of what you’re saying, and in general I agree. Although I think the macro arguments are about much more than multipliers, I rather think you are addressing this specifically to current policy macro arguments, am I wrong?

So financial economics really isn’t much more than a specialty within economics. Econometrically, asset pricing is more like time series work, whereas corporate finance is microeconometrics, and especially panel methods. That probably has a lot of commonality with labor econometrics.

Regarding modeling the variable path, see my post on asset pricing modeling below.

kyle8 December 16, 2011 at 5:53 pm

DK it seems to me the type of econometrics you are talking about, looking at a thin slice of the economy so to speak, is fine and dandy.

However, you must know that as the complexity of any system rises, the problems with prediction rise, not arithmetically, but geometrically.

That is the trouble with any modeling of the economy as a whole.

Ubiquitous December 17, 2011 at 7:25 am

But if you were to ask me “what will engineering employment and wage trends be like over the next twenty years” I could probably give you intelligent speculation,

What, pray tell, is “intelligent speculation”? Sounds like weasel words; the sort of rubbery phrase that can (i) mean anything you want it to mean, and (ii) also provide “plausible deniability” when it turns out to be completely inaccurate.

but there’s no way to “test out of sample” the sort of empirical work I’ve been doing on this market. Lots of things could influence that market over the next twenty years.

In other words, you can tell a narrative, a story, about what might happen — which any novelist or short-story writer can do just as well — but in order to make that “might happen” plausible, you have to assume that either nothing changes, or that the change is a mere extrapolation according to a known function from trends that you are already aware of.

Malthus made an “intelligent speculation” regarding wage rates and population growth; turned out he was dead wrong. It just never occurred to him that workers wouldn’t keep banging out children to subsistence as their wages rose. Those who made “intelligent speculations” in the horse-driven 19th century, that by the 1930s there would be huge mountains of horse manure everywhere just couldn’t foresee one small change: the automobile. Those who looked at engineering wage rates in the 1940s couldn’t foresee the computer industry.

They can’t hide behind the weasel words “intelligent speculation.” They were simply dead wrong.

Again – think of biology something I think we all agree is a science.
True. As long as what you’ve got in mind is actually “biology” and not something else. Biology is not simply the study of anything that has to do with living organisms; after all, “ethics” has something to do with a living organism called Man but it scarcely can be seen as a sub-discipline of biology.

We know a lot about primate behavior.

See what I mean? Animal Behavior is Animal Behavior; it’s not Biology.

We have a lot of data on it,

It’s all based on empirical evidence; i.e., watching what animals do. None of it is based on what the hard sciences have in addition to their body of empirical observations, which is “law”.

and we’ve modeled it and come to conclusions about primate behavior.

You’re a sublime bullshit artist, DK. What “models” of animal behavior are you talking about, and how are they similar to models in science that everyone agrees are true models; i.e., the perfect gas model of Boltzmann or the old solar-system model of the atom.

That doesn’t mean you can walk up to Jane Goodall and ask “who among your group of primates will still be a live five years from now, and what will they be doing on December 16, 2013?”.

You used “Who” as a pronoun for primates instead of “Which”? Interesting choice. Anyway, your question cannot be answered by Ms. Goodall because it’s not a question bearing on animal behavior, but, rather, on veterinary medicine. A vet could say “They’re all in good health, so if they’re not released from captivity, they will all be alive five years from now.

There’s a big difference between having a good model for understanding something and being able to predict something. Most of our models are conditional models. Prediction of the sort we’re talking about is always unconditional.

The difference is that one of them isn’t a model. Even you were forced to split the concept into two, claiming that there are “conditional models” and “unconditional models.”

Anyway – I raise the Jane Goodall/primate issue because if you accept that you should be able to accept what I’m saying about economics. After all, economics is just the study of the social behavior of highly intelligent apes.

Cool. That passes for sophistication in graduate school, I suppose. So then Goodall is really a kind of “primate economist” by your lights. There’s no real qualitative difference (merely one of degree) between Goodall’s “40 Years at Gombe” and Keynes’s “General Theory.” The two books lie on a kind of continuum for you, as opposed to their being about completely different things.

That explains a lot about your posts, Daniel. Thanks.

jjoxman December 16, 2011 at 12:16 pm

As a financial economist, I rather feel Prof. Hayek’s claims about modeling, and the ‘quants’ most keenly. Asset pricing theorists, including those who work on derivative pricing, are probably the worst (or best, depending on one’s point of view) offenders of physics envy. Well… probably not envy, since many quants are actually physicists. But anyway, we use the models of physics quite a bit in financial modeling of asset prices. Corporate finance is more game theoretic, although we are now bringing IO into the mix, which is an exciting development.

In fact, the use of physics, or the realization of the potential to use the math of physical relationships in finance, dates back to Bachelier at least if not before. He was the first, in a doctoral dissertation that almost cost him his doctorate, to point out that stock prices moved according to a Wiener process. That is to say, individual stock price innovations were effectively random. Over the years, we’ve been able to use stochastic calculus to reasonably approximate stock price motions. The most complex models include drift, volatility, and a jump factor (surprise! you just lost a ton of money!).

All that said, we do not actually think our models can predict the future stock price movements. The models are especially useful in pricing derivatives because more complex derivative instruments don’t lend themselves to closed-form solutions. So we simulate potential asset price paths about 10,000 times, figure the option (for example) value in each case, and bring that back to the present.

But such models are of limited usefulness! They don’t predict squat. Yes, we model jumps that could happen, but we don’t know when somebody’s fat finger is going to hit the wrong key. And, our models are calibrated using historical data. MBS prices didn’t have much default risk built into them because when MBSs were pioneered and finally became common, defaults were very few.

Finally, it must be stressed, beyond any question, that theory and practice in finance are quite distant. The practitioner must employ human judgment in applying these models, especially with regard to inputs. If you think you can use a stochastic relationship of stock prices with just the right calibration to predict the future, you are going to lose boatloads of money in the market. Because we can’t predict human behavior.

Actually, in a lot of ways, stock prices are aggregates. Individual ones, I mean. They reflect the overall opinion of investors and potential investors in a particular stock. So our models are just grabbing that opinion. Savvy practitioners know when to disagree – models don’t.

That’s quite a ramble, and I didn’t have a point really. Just wanted to illustrate how we professional modelers/forecasters view it.

Daniel Kuehn December 16, 2011 at 12:31 pm

The ramble is quite nice for those of us that are not as informed about finance!

Troll Watch December 16, 2011 at 1:01 pm

You should inform yourself as soon as possible.

txslr December 16, 2011 at 1:20 pm

I have been in the financial economics business for more years than I care to admit, and I even made a fair amount of money selling Value-at-Risk models to commodity traders. One thing I know with certainty is that the modelers knew – and they repeatedly informed the users – that the models were imperfect. No one did not know that actual return distributions are heavy-tailed, that many markets are subject to jumps and regime shifts, that volatilities cluster, that correlations are not stable, etc. Mandlebrot and Fama both noted that actual returns are not normally distributed many years ago.

In my experience the problem has tended to be that the process by which decisions are made fails to take adequate account of the model weaknesses that everyone understands are there. Better models would, of course, be great. But improving the processes by which decisions are made would be even better.

jjoxman December 16, 2011 at 1:25 pm

Yes, this is all quite true, and why I think Taleb’s work is over-rated. Or, at least, his points about the ‘black swans’ not being modeled by practitioners.

Finance – where all models are wrong, but some are less wrong than others.

Methinks1776 December 16, 2011 at 1:44 pm

May I steal that last line? I think it would look rather good on my wall.

First of all, brilliant and informative “ramble” above, JJoxman. Taleb has an especially bad habit of assuming that tail risk is persistently underpriced, which means all teeny options are cheap and they’re all buys. That’s just not true.

txslr December 16, 2011 at 1:56 pm

Vols don’t smile enough? :-)

jjoxman December 16, 2011 at 2:21 pm

All yours! No copyright here.

Methinks1776 December 16, 2011 at 4:21 pm

:)

Methinks1776 December 16, 2011 at 5:22 pm
txslr December 16, 2011 at 1:52 pm

I agree on Taleb. He seems to have made a very good living taking what was common knowledge and then claiming that no one ever thought of it until he came along.

GAAPrulesIFRSdrools December 16, 2011 at 11:49 pm

Actually he’s pretty good at attributing to Mandelbrot and Popper.

kyle8 December 16, 2011 at 5:57 pm

models of that sort, In my View, would only have the following limited usefulness. I would use them to model my position under a variety of probabilities such as high inflation, low inflation, high growth, low growth, etc.

Then I might have an idea as to what my potential risks would be. I would still have to make a guess about what the future really held in store before I would make a decision.

jjoxman December 16, 2011 at 9:57 pm

Well, I actually do model inflation impacts on stock prices quite a bit. And sure, that’s a main way modeling is used.

The idea is to think up as much possible bad stuff and model it – to see what can happen to the portfolio. Whether practice = ideal, I dunno.

I Miss Nixon December 16, 2011 at 8:57 pm

based on limited know of surveying in the restaurant industry, are their any attempts to price stocks, bonds, etc., based on psychological barriers or numeric anchoring.

For example, Denny’s bankrupted itself because it advertised $1.99 for breakfast for so long that it could never raise prices, regardless of what it did.Gallop type surveys showed that customers were so anchored to $1.99 that they could not be moved to pay $2.25

jjoxman December 16, 2011 at 9:56 pm

Is that first paragraph a question? Please to rephrase if so.

Troll Watch December 16, 2011 at 12:55 pm

Hayek wasn’t really a scientist or a mathematician. That explains his disparaging of the scientific method. Keynes was highly skilled in statistics and math. Probability is not an especially easy subject.
http://www.amazon.com/A-Treatise-On-Probability-ebook/dp/B004EEPOAY/ref=sr_1_1?ie=UTF8&qid=1324058063&sr=8-1

GAAPrulesIFRSdrools December 16, 2011 at 4:59 pm

Except he didn’t disparage it, he simply said it wasn’t as applicable to economics as the physical sciences. That’s not disparagement.

txslr December 16, 2011 at 1:05 pm

There can be many purposes for modeling, I suppose. The purpose of practical financial models is to guide decision making at a micro level. Consider the dilemma faced by a corporate manager trying to decide whether a proposed capital investment is worthy. His normative objective is to maximize the wealth of his shareholders, whose wealth is determined in a market (I am assuming that the corporation’s shares are traded). So in deciding whether to invest or not the manager is necessarily making a forecast of the response of the market to the decision. To do so he must have a model. It may be an unexamined mental model or it may be a complicated model of how markets respond to expectations, timing of cash flows, risk, etc. – but he MUST have a model.

Troll Watch December 16, 2011 at 1:08 pm

Hayek was an obscurantist. His claim that we can’t know things well enough to act on them was another way that he shilled for the capitalist class to protect them from the common man. You can listen to him yourself on Youtube. He says nothing of interest except to act pompous and erudite. He disgusts me.

kyle8 December 16, 2011 at 5:59 pm

I am sure that you disgust yourself as well.

jjoxman December 16, 2011 at 1:41 pm

I want to be clear about my position on statistical modeling. It is a tool, like anything else. If you want to be an Austrian praxeological type, or a neoclassical type, fine. You can still supplement your theory with econometrics to a greater or lesser extent. But you have to understand the limitations of your testing. I’m essentially arguing for a blend of Friedman and Misesian standards here. Your theory must be logically sound and be able to describe reality.

Modeling is no substitute for other forms of reasoning, including historical narrative. If you want to learn the history of banking in the U.S., Rothbard is probably more important than Friedman & Schwartz, but both together is way better than either alone.

In other words modeling is a complement to historical narrative and theorizing (in multiple ways). A good economist uses as many tools as possible to understand the world. And the trouble with statistical modeling is that it isn’t complex enough to handle all the stuff humans can do. It may not have the capacity to become that complex. That doesn’t mean it can’t help us understand the world. But it does mean that one shouldn’t get stuck on statistical modeling as the only way to do economics.

Mesa Econoguy December 16, 2011 at 6:19 pm

Brilliantly said, and completely agree having had the same experiences myself.

As all traders know, when the excrement meets rotating blades, your models likely ain’t gonna work so well.

carlsoane December 16, 2011 at 7:14 pm

So, what do those traders rely on to guide their next action after the excrement meets the rotating blades? Dice?
I’d bet they just start substituting their implicit models for the explicit ones that they have lost confidence in.

Mesa Econoguy December 16, 2011 at 7:20 pm

Yes.

Most I know either revert to instinct, depending on the situation, or duck/run for cover.

When things like May 6, 2010 happen, many models – but not all – become useless.

Methinks1776 December 16, 2011 at 8:21 pm

Most I know either revert to instinct, depending on the situation, or duck/run for cover.

Hey, isn’t that the same thing?

After 9/11, the market was so fragmented and dysfunctional for a couple of weeks that a lot of people couldn’t use their models at all. The more complicated, the more inputs required, the less usable the models were. The just didn’t trade.

Mesa Econoguy December 16, 2011 at 9:06 pm

Yes.

Gisele Bundchen is always useful, irrespective of market conditions.

Methinks1776 December 16, 2011 at 7:55 pm

So, what do those traders rely on to guide their next action after the excrement meets the rotating blades? Dice?

Prayer.

No, we don’t toss out our models. If we’re using them as a guide, we continue to do so. A good trader is always sanity checking against the market anyway. The natural response to an increase in market volatility is to widen your market.

Mesa Econoguy December 16, 2011 at 8:13 pm

Or just back away. :)

jjoxman December 16, 2011 at 9:55 pm

F to the Y I, Carl,

When the world starts going kerflewey (that’s a technical term) I move hard into cash. Actually, I maintain a pretty large cash float in general.

But that’s really next to impossible for most institutional traders (like mutual funds) that are available to the public.

Carlsoane December 17, 2011 at 8:14 am

That makes sense. The interesting thing to me is that both methinks and you have described how in times of stress, your models require fewer inputs or produce coarser grained outputs(e.g. hold cash until indicators fall within historical norms) I look at those as just some more rules for your models. Regardless of whether they have been coded into algorithms driving the software models used by the trader, they are “coded” into the mental model driving the trader’s actions. They become simpler because our mind is not as capable of tracking as many variables as our computers can. And the real model is the combination of the software model and the mental model.

Methinks1776 December 17, 2011 at 8:46 am

No, Carlsoane, you have it backwards. The human brain is better. Sorry, I think it’s Mesa’s and my fault for doing too much kidding around in our responses. We don’t actually pray. In fact, one of the earliest lessons I learned is if you’re hoping and praying you should get out of your trade because it’s no longer a good trade.

After 9/11 the market was very wide (bids and offers were unusually far apart) and not everything was trading, so the inputs into very complicated models that required a lot of inputs (I’m thinking specifically of some of the fixed income derivatives models) just weren’t available, so the models were unusuable. In at least one case, the models (built by the most brilliant quant I’ve ever met) were complicated but simple enough for the team to patch together data. For instance, they literally called brokers on the phone to get Eurodollar futures prices and got enough treasury prices to bootstrap a curve out of them. Without pricing models, it’s too hard to trade complex derivatives like Bermuda Options. It’s impossible to price them by hand. We still need models.

The human brain is able to process and react to new information in ways that models can’t. A very simple example would be a model producing a price for an exchange traded security that seems in line with the market, but your offer keeps being lifted. It’s never good when you’re doing all the volume. The trader moves up his offer because he suspects a hidden buyer that the model hasn’t recognized because it’s hidden.

There are a million different models for trading countless products of varying complexity using different strategies. So, it’s difficult to talk about what “we” do under certain circumstances because “we” are all doing different things.

We don’t want to stop trading in times of market stress. Although it’s a scary time, it’s also the most lucrative time to trade. You’re just not going to let your algos do the trading. The human brain is much better at recognizing and reacting to paradigm shifts.

Carlsoane December 17, 2011 at 11:51 am

Fair enough. The brain can both handle more and less complexity. My comment looked just at its Inferiority at handling structured input like trying to handle an algebraic equation with 15 variables versus it’s ability to help you find your way to safety on a battlefield.
What I am hearing though is that a very complicated model underlies the actions. I think your brilliant quant’s actions illustrate that. He must have known the limits of the encoding of the model in the program to know how to revise it under pressure. And the rules for first knowing a revision was needed and then for what those revisions needed to be come from the mental model he had of how things interact.

Methinks1776 December 17, 2011 at 11:53 am

The appearance of the volatility smile is a concrete example of the market adjusting a model.

Black-Scholes attributed a single log-normal volatility for all strike prices for a given expiration. After the 1987 market crash, a curve appeared in the in implied volatility. Options with strikes higher and lower than the at the money strike began trading at different implied volatilities. The implication of the appearance of the smile or skew is that Black-Scholes was mispricing in and out of the money options – the deeper in or out of the money, the more severe the mispricing.

The smile was a market development which means that it probably (I’m guessing) appeared when a flood of put buyers materialized during the 1987 crash. The market makers likely responded by moving up their market and the equilibrium point (the price at which buyers were still willing to buy and sellers were not losing their shirts) settled at a higher point than the Black-Scholes model predicted using the single log-normal implied volatility for all strikes. The implied volatility for strike prices lower than at the money strikes were clearly higher. In other words, the traders abandoned the model and responded to changes in the market, forever changing how the Black-Scholes model is used.

Skews have since appeared in every volatility market and they’re all different. What determines the skew is what the likely jump will be. Index options are more likely to have a downward jump (of all the unknowns, there are more unknowns that can cause an index to move lower than move higher). The smile is really a skew where options with lower strike prices trade at higher implied volatilities than options with higher strike prices (relative to at the money options). In general, stocks (particularly less liquid stocks of smaller companies) have more symmetric jumps up and down, so their volatility smiles actually look like a smile (a “U”). The skews and smiles are dynamic – they are constantly being adjusted by market participants.

The point is, the adjustment to the model was and is continually made based on human beings assessing market realities – perceiving the changes in behaviour of fellow human beings – adjusting the model to fit the reality.

This is just one illustration of the adjustments to inputs that JJoxman wrote about in his comments.

vidyohs December 16, 2011 at 7:30 pm

Thank you. That was clear enough for even a dumb ass like me to understand and appreciate.

To your ending I would add, that one should not get stuck on statistical modeling as the way to make public policy, as it seems the government as been wont to do for so long. Predicting, forecasting, modeling human behavior, needs, desires, and wants are possibly the most impossible thing I can think of.

It makes me wonder, is democracy all it is cracked up to be by the hoi polloi. LOL :-)

jjoxman December 16, 2011 at 9:53 pm

Actually, one of my (many, many) reasons to be a libertarian is because all models of human behavior fail.

The only thing that works is letting people be.

Democracy blows. Everything else is worse.

Methinks1776 December 16, 2011 at 9:13 pm

I quite like this. The link to the article by Derman and Wilmot from which Aaron created this oath is in the blog post.

The Derman-Wilmott Oath (the model makers Hippocratic oath of)

->I will remember that I didn’t make the world and that it doesn’t satisfy my equations.

->Though I will use models boldly to estimate values, I will not be overly impressed by mathematics.

->I will never sacrifice reality for elegance without explaining why I have done so. Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.

->I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

-> [added by Mark Palko:] Our model only describes the data we used to build it; if you go outside of that range, you do so at your own risk.

http://biologicalposteriors.blogspot.com/2011_02_01_archive.html

Mesa Econoguy December 16, 2011 at 9:54 pm
muirgeo December 16, 2011 at 9:59 pm

As far as I can see Hayek was envious of Keynes success… so he went with the only fall back position a person sure to lose the chess match can choose…a stalemate. And by describing the economy as so complex no one can predict anything about it that’s what he was trying to do. We see the same thing from creationist and climate change deniers. Mire he debate in uncertainty and hope for a stalemate. Sorry Hayek… it’s a checkmate and you have no more moves.

Mesa Econoguy December 17, 2011 at 1:19 am

I love satire.

I Miss Nixon December 17, 2011 at 10:27 am

Letter from Margaret Thatcher to Friedrich Hayek

February 17, 1982

“Thank you for your letter of 5 February. I was very glad that you able to attend the dinner so thoughtfully organized by Walter Salomon. It was not only a great pleasure for me, it was, as always, instructive and rewarding to hear your views on the great issues of our times.

I was aware of the remarkable success of the Chilean economy in reducing the share of Government expenditure substantially over the decade of the 70s. The progression from Allende’s Socialism to the free enterprise capitalist economy of the 1980s is a striking example of economic reform from which we can learn many lessons.

However, I am sure you will agree that, in Britain with our democratic institutions and the need for a high degree of consent, some of the measures adopted in Chile are quite unacceptable. Our reform must be in line with our traditions and our Constitution. At times the process may seem painfully slow. But I am certain we shall achieve our reforms in our own way and in our own time. Then they will endure.”

Correspondence in the Hayek Collection, box 101, folder 26, Hoover Institution Archives, Palo Alto, CA.

I Miss Nixon December 17, 2011 at 3:49 pm
Per Kurowski December 18, 2011 at 5:41 am

The worst sinners, of believing in models, in this case risk-analysis and credit ratings, are the bank regulators… They, instead of regulating for the case the risk-models and credit ratings used by the banks would turn out to be wrong, regulated as if these models and credit ratings never were to be wrong… and for instance, allowed the banks to invest in triple-A rated securities or lend to infallible sovereigns, for instance Greece, holding only 1.6 percent in capital… which means allowing banks to leverage over 60 times…

Over 60 times leverage lending to Greece? Talk about faith!

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