The Value of Simple Models, with Examples of Economic Dynamics
Guest post by Geoff Davies
Many people, including many heterodox economists, understand that the neoclassical equilibrium approach to understanding economies is futile and misleading [1], because modern economies are far from equilibrium. The neoclassical prediction of equilibrium or near equilibrium requires a string of patently absurd assumptions. However the development of better theories seems to be significantly hindered by a feeling that any superseding theory has to be thoroughly quantified before it can be useful, and a feeling that the neoclassical theory has set a benchmark for sophisticated mathematics that must be matched before another theory can be respectable. Less fundamentally there seems to be a common perception that empirical insights can only be gained through elaborate statistical treatments of observations.
Here I offer some discussion from my experience as a natural scientist, and some examples regarding the Global Financial Crisis, to counter these hindrances. Useful and relatively simple models can be constructed that can immediately overcome major neoclassical limitations, for example by permitting non-equilibrium behaviour. The solution of the mathematics can be done using very standard numerical integration methods that are readily available in commercial packages. Mathematical machismo is not required. There are also situations in which the empirical lesson is obvious with no analysis, as will be noted here.
I should be clear that there are certainly many modellers who operate outside neoclassical confines, reported for example in Beinhocker’s excellent survey of “complexity economics” [2]. The lessons offered here will not be news to them. Also some of them are constructing quite complex models that are nevertheless very instructive, such as models with many interacting adaptive agents. This article is prompted by my reading of some heterodox blog discussions, and is addressed to anyone who may have some difficulty seeing how to move beyond the neoclassical approach. Nor are the models here are offered as original investigations, though they may lead to such.
Read the whole piece on Geoff’s blog.
Discussion (25) ¬
That shouldn’t be of any surprise. The mathematics with the Sun at the centre of the solar system are clean and elegant. The mathematics required to put the Earth at the centre of the solar system are complex and ugly by comparison.
Both mathematical models work, but only one corresponds with reality.
Dear Professor Keen: I hope I am not becoming a pest. I would like to pass on a link
to another paper by Alan Kirman, entitled “Walras Unfortunate Legacy ” dated Dec.
2010, Document de travail No. 2010-58. Kirman has extensive citations to Walras’
unpublished letters, in particular as they bear on “tatonnement”, and his seeking of
mathematical approbation for his analysis. The paper is about 26 pages, and can be
directly linked to on the internet by searching for “Alan Kirman Walras Unfortunate Legacy”. I hope the source material and citations will be of some use for the “Magnum
Opus” for which we must patiently wait. Best regards, RK
Anything but a pest Robert–that looks like a very useful reference that will probably make it into the second edition of Debunking Economics. Thanks for spotting it and passing it on.
I had a minor epiphany re reading the Walras paper this morning. The reason usually
given for the aggregation assumption to a representative individual is that it allows
the mathematical tractability to arrive at an equilibrium with the properties of uniqueness and stability. The “tatonnement” process is based purely on prices and
quantities. But the representative individual also solves a more “nefarious” problem,
with roots from Adam Smith to John Von Neumann. It is this: “People of the same trade seldom meet together, even for merriment or diversion, but the conversation
ends in a conspiracy against the public.” (Adam Smith) A representative individual
is incapable of “herding” behavior, but equally important, he cannot “collude” with
himself. An economic theory where large, influential entities cannot, by definition, collude with one another, will happily deny the possibility of large distributional
distortions which Smith, and countless others following him, have observed.
Useful comment for me too Robert. Interesting, as Kirman figured out that the relatively simple interactions among ants can lead to chaotic collective behaviour very different from what a “representative ant” would do: Ants, rationality and recruitment, Quarterly Journal of Economics, Feb 1993.
As a scientist I struggle to understand how neoclassical theory went so far astray, and the recent Kirman paper adds a bit of insight there.
screaming claxons
“Risky loans stage comeback”
http://www.ft.com/cms/s/0/9f7c528c-4da3-11e0-85e4-00144feab49a.html#axzz1GWVSyNmY
It seems the boys in the know are getting all they can out of it before the second quarter starts.
“Meanwhile, private equity-backed companies are borrowing at a record rate this year to pay special dividends to owners. At $15bn, the pace follows a record year for private equity-related dividend deals in 2010.”
Hey Steve, I’ve been reading your blog but I’m still a bit confused about why aggregate debt matters. Paul Krugman says that it’s the distribution of debt, not net debt that matters, because net debt is “money we owe to ourselves”. I suppose what he means is, say, if everyone suddenly became creditors and debtors to the order of an extra $50k, no one is worse off and the system does not become more unstable. Is the argument against it that, given the same equity, it’s better to have less debt because assets can be illiquid? Or that high levels of aggregate debt is always a symptom of ponzi finance?
Because credit is created by banks “ex nihilo” and adds to aggregate demand beyond that generated by the sale of existing goods and services: aggregate demand is the sum of income plus the change in debt (credit). Krugman’s world is a zero sum game where there are no such specific institutions as banks that have the capacity to create spending power endogenously.
Read my “Roving Cavaliers of Credit” post for more details
So it’s the process by which we reach a high level of aggregate debt that matters, not high aggregate debt in the abstract?
Dragunov
In Paul Krugman’s world, everyone has perfect foresight and there is no such thing as credit default. If one million people suddenly lend each other $50,000, then the expected loss is one million times $50,000 times the average probability of default. If the default probability is one percent pa, then the expected annual loss is $500 million. When lenders lose money, trust (credibility) is lost and the lending process grinds to a halt, as we saw with mortgage backed securities and impact on the global financial crisis. Paul Krugman doesn’t live in the real world.
If the debt is used to fund Ponzi schemes, then it is a fraud to deceive lenders to believe the borrower has higher equity as collateral to justify even more debt, in an ever expanding spiral (or feedback loop) of ever higher debt/ equity ratio. Every speculative bubble that I know in history involves expanding debt, because it’s only with leverage, that Archimedes said: “Give me somewhere to stand, I could move the earth” (or something similar).
Another Australian Heretic worthy of mention:
Helen Caldicott, M.D.
The Nuclear Message
http://www.globalresearch.ca/index.php?context=va&aid=23663
Why not? Rake in as much fees and bonuses as you can. Bad loans will be paid for by taxpayers, through government bailouts. Nothing has changed.
In part it is as Lyonwiss explains, but the absolute level also matters since change in the change of debt can become a large part of change in aggregate demand only if debt itself is large compared to GDP.
Steve,
Sorry to stray here, but I found this Saul Eslake piece printed in the Fairfax press today. He shares your views on the FHOG!
http://www.theage.com.au/business/billions-in-handouts-but-nothing-gained-20110315-1bvvs.html
Another more recent and excellent article by Geoff’s :
http://betternature.wordpress.com/2011/03/14/gillards-hollow-american-dream/#more-525
And mirrored here:
http://www.ikners.com/?p=1932
Comment by John Pilger:
“As the Washington historian William Blum has documented, since 1945, the US has destroyed or subverted more than 50 governments, many of them democracies, and used mass murderers like Suharto, Mobutu and Pinochet to dominate by proxy. In the Middle East, every dictatorship and pseudo-monarchy has been sustained by America. In “Operation Cyclone”, the CIA and MI6 secretly fostered and bank-rolled Islamic extremism.”
Comment by me: I had posted this elsewhere back in July August 2005.
” July 13-15, 2005 — New U.S. air base under construction in Australia
“Our Australian sources report that a new U.S. air base is currently under constrction in the Northern Territory of Australia. A new air strip is reportedly under costruction in the Bradshaw Range in the sparesly populated “Top End” region of Australia.
An air training and bombing facility in the Delamere Test Range is also being upgraded for American forces.”
“There are reports that the bases in the Northern Territory may replace those in Okinawa if the U.S. withdraws from the Japanese island.”
Comment: This is not just a M’s Gillard issue, as it involves the whole treacherous and cowardly betrayal culture at all levels of the Australian Penal Colony Government system on behalf of the United Kingdom.
It is time to “let the dead bury their dead” and move on…
On socio-economic matters Nuclear:
The probability of the Japanese crisis becoming far worse and impacting the whole of the Northern hemisphere and killing slowly many millions of people are now extremely high:
Only the insane, totally mad and the blind ignorant would even consider radio-active uranium based Nuclear reaction as our global energy source. If you disagree, talk to me in a few months when the affects become apparent. The situation is already bad and for the argumentative, let me instill this fact into the conversation:
Natural telluric events do happen and will continue to occur, and we cannot control them as most of us, do not understand them and prefer it that way. Besides this, human nature will always place humanity in risk for the purposes of self-agenda and profit.
An Australian Lady:
Dr. Helen Caldicott | http://www.helencaldicott.com/
http://www.globalresearch.ca/index.php?context=va&aid=23663
I urge people to stop utilizing the main stream media as their source of knowledge and turn to people such as Dr. Caldicott, et al, who have the integrity and the knowledge to guide our thinking and actions in such matters.
The Press, that is the Main Stream Media is merely “entertainment” concocted and manipulated by uneducated and irresponsible but monied interests. That is, they profit by the torquing of your opinions.
For Australians in Australia we will in most probability not be effected due to the nature and physics of the the atmospheric hemispheres. “Lucky country”.
http://globaleconomicanalysis.blogspot.com/2011/03/global-crisis-in-leadership-everywhere.html
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“Global Crisis in Leadership Nearly Everywhere You Look”
“”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”"”
Finally, I have a supportive second opinion and from Mish which I take most positively
What we are experiencing is a:
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Global Leadership Crisis (GLC)
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and I have been say this for over 3 years, maybe longer.
Steve
This is not directly related to this thread. But it is directly related to two of your main topics: house prices and mainstream economics:
http://www.businessspectator.com.au/bs.nsf/Article/Australian-property-prices-housing-bubble-pd20110317-F24WP?OpenDocument&src=kgb
You need to register (free) to access Business Spectator. The comments on this mainstream-view article are mainly derisory of the content. The article is also panned here today:
http://www.moneymorning.com.au/
My observation is that the mainstream is starting to lose credibility on this issue. From my personal interest on economics methodology, it is another example of how the public could be duped by apparently “reasonable” arguments, which are really not relevant and unsupported by empirical evidence, i.e. spin. The Reserve Bank of Australia argues and discusses economics in much the same way.
Yes I saw that Lyonwiss–even on neoclassical standards, that was a low grade and boring piece of work. I’m glad the BS readers are panning it.
On matters Australian – Nuclear, socio-economic, political and the probabilities for future events and if we are to be able to read Mr Keen’s second edition of Debunking Economics…
then perhaps you may like to read my latest post in the meantime @
http://verbewarp.blogspot.com/2011/03/operation-death-star-australis.html
My Grandfather who raised me over 60 years ago, always advised me to ‘never believe government and never trust a banker’. He was a wise man.
Today, the whole socio-economic forces are rapidly accelerating out-of-control, whilst pressures on these containments that is to say, governing principles and constraints; beliefs and paradigms are highly volatile. Any slight motion can become instantly, a monumental event. The Message is to keep your eyes of the bouncing ball as it is in such times that our politicians default to mechanisms crude and murderous. Such is history.
The future is about those blessed with the ability to think constructively and consequently influence future event. This is democracy.
Be a part of a better sane future with a focus on integrity and values.
Prof. Keen,
I have the impression that the main stream Australia economists argue there is no housing bubble, which I believe is a replay of the U. S. in 2005-2006. Is this the case?
Yes George, and there was a particularly ponderous piece on that front published yesterday, as Lyonwiss pointed out:
http://www.businessspectator.com.au/bs.nsf/Article/Australian-property-prices-housing-bubble-pd20110317-F24WP?OpenDocument&src=kgb
However even this is weakening as the general populace is starting to admit there’s a bubble. I have given a couple of talk recently at which even mortgage brokers admitted there was a bubble.
Thanks Prof.
Congratulations Geoff Davies! As an ex-systems builder, I am convinced that a systems view of economics is the only way to go.
#1: In a complex system there can be many equilibrium states (I would prefer to say “fairly stable” states, since “equilibrium” implies no change, which of course is not what we see).
#2: Both stability and instability are driven by feedback loops – they are the control mechanisms.
#3: Above all, theory needs to explain empirical data.
#4: Even simple models are pretty useless if all they do is illustrate a garbage theory. Garbage in means garbage out, even if the model itself is perfectly rigorous and immensely intellectually satisfying.
#5: We badly need a new theoretical base for economics. While we just nit-pick at neo-classical theory the working economists have nowhere else to go. Chuck the lot out, I say, and start again. Then cherry-pick any old bits that are useful. Steve, you may be our best bet! I hope Debunking Economics 2 is up to the task?!