The Value of Sim­ple Mod­els, with Exam­ples of Eco­nomic Dynam­ics

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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.


About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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  • 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.

  • Robert K

    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.

  • Robert K

    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.

  • Geoff Davies

    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.

  • DrBob127

    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.”

  • Dra­gunov

    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

  • Dra­gunov

    So it’s the process by which we reach a high level of aggre­gate debt that mat­ters, not high aggre­gate debt in the abstract?

  • Lyon­wiss

    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

  • Lyon­wiss

    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.

  • Pingback: The Value of Simple Models, with Examples of Economic Dynamics | Better Nature: commentary by Geoff Davies()

  • 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.

  • Vfe

    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
    ****************************************************************
    “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:
    ********************************************
    Global Lead­er­ship Cri­sis (GLC)
    ****************************************

    and I have been say this for over 3 years, maybe longer.

  • Lyon­wiss

    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.

  • George H

    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.

  • George H

    Thanks Prof.

  • Harry

    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?!