There’s Still Hope for Modern Economists

By: Barry_Elias

A recent blog of mine, dated Nov. 12, 2010, suggested that modern economists have modeled the economic decision-making process for many years with a high degree of inaccuracy.

They implemented a methodology referred to as the dynamic stochastic general equilibrium (DSGE) model.

In that article, I cited pre-eminent economists that concurred with that view: Dr. Dr. Robert Solow, professor emeritus at MIT and the 1987 Nobel Laureate in Economics; Dr. Narayana Kocherlakota, President of the Minneapolis Federal Reserve Bank; and Dr. Ricardo J. Caballero, an MIT economist with the National Bureau of Economic Research (NBER).

Testifying before the House Committee on Science and Technology Subcommittee on Investigations and Oversight on July 20, 2010, Dr. Robert Solow said: "But the basic story (referring to DSGE) always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This cannot be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on."

Dr. Narayana Kocherlakota, President of the Minneapolis Federal Reserve Bank, was more self-critical when he wrote this past May, "I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world.”

That is a very strong statement; I commend his straightforward honesty.

Dr. Caballero concurred and stated in a Sept. 27, 2010 paper: "In this paper I argue that the current core of macroeconomics — by which I mainly mean the so-called dynamic stochastic general equilibrium (DSGE) approach — has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one.”

I reiterate and highlight the aforementioned in light of a recent Wall Street Journal piece, dated November 30, 2010, 18 days later.

The following are excerpts from that article:

"In the wake of a financial crisis and punishing recession that the models failed to capture, a growing number of economists are beginning to question the intellectual foundations on which the models are built. Researchers, some of whom spent years on the academic margins, are offering up a barrage of ideas that they hope could form the building blocks of a new paradigm."

P hysicist Doyne Farmer, a leading expert in complex systems at the Santa Fe Institute, told the Journal that the problem is that the models bear too little relation to reality. People aren't quite as rational as models assume, he says. Advocates of traditional economics acknowledge that not all decisions are driven by pure reason.

The 58-year-old Mr. Farmer has spent much of his life trying to figure out how to predict the future, the Journal reported.

"Mr. Farmer sees a perhaps greater flaw in the models' mathematical structure. A typical 'dynamic stochastic general equilibrium' [DSGE] model — so called for its efforts to incorporate time and random change — consists of anywhere from a few to dozens of interlinked equations, which must agree before the model can spit out a solution. If the equations get too complex, or if there are too many elements, the models have a hard time finding the point at which all the players' preferences meet."

"To keep things simple, economists leave out large chunks of reality. Before the crisis, most models didn't have banks, defaults or capital markets, a fact that proved problematic when the financial crisis hit. They tend to include only households, firms, central banks and the government. They also commonly use a single equation to represent each player, impairing the models' ability to explain the unexpected outcomes that can emerge when millions of different people interact."

'"You are limited by what you can solve," Mr. Farmer told the Journal. "It puts the whole enterprise in a straitjacket."'

"His proposal: Create a richly complex, computer-based simulation of the economy like those scientists use to model weather patterns, epidemics and traffic. Given enough computing power, such 'agent-based' models can include millions of individual players, who don't have to be rational or agree with one another. Instead of equations that must be solved, the players have open-ended rules of behavior, such as, 'If I've just turned 55 and I'm feeling blue, I'll buy a sports car.'''

Toward this end, Mr. Farmer is attempting to coordinate a team of highly qualified experts, who can identify and properly model these underlying parameters and dynamics. He anticipates such a system may take many years to develop, but projects the cost to be a fraction of the $1 billion annual budget conferred upon the National Weather Service.

During the past two years, I have watched and listened in utter amazement as chief executive officers and other well-positioned individuals at prominent financial institutions claimed (I paraphrase): no one could have predicted the certainty and severity of the crisis.

As stated in a previous article, I divested from the equity market on March 17, 2008: that day JP Morgan acquired Bear Stearns with government guarantees and the Dow Jones Industrial Average was 12,000. Six months later it declined to 6,500.

That type of statement by the financial cognoscenti suggests, at a minimum, an insufficient level of competence and/or honesty: none of these possibilities are admirable.

I welcome the opportunity to develop a more robust, elegant, and practical methodology for an increasingly more complex, interconnected, global environment.

By Barry Elias

Website: http://www.moneynews.com/blogs/Elias/id-114

eliasbarry@aol.com

Barry Elias provides economic analysis to Dick Morris, a former political adviser to President Clinton.

He was cited and acknowledged in two recent best-sellers co-authored by Mr. Morris: “Catastrophe” and “2010: Take Back America - a Battle Plan.” Mr. Elias graduated Phi Beta Kappa from Binghamton University with a degree in economics.

He has consulted with various high-profile financial institutions in New York City.

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