We all use models in our daily lives, because they help us to make sense of what are often very complex problems. Models simplify, organize, and categorize the variables in an uncertain world so that we can better understand the impacts of our decisions. But they DO NOT, ever, have the power to tell us what to do. You don't even need to know a thing about Black-Scholes (and trust me, a lot of people who should know a lot about it... don't) in order to accept that assertion as fact.
The intelligent person knows to use a model only as a guide to confirm (or refute) what our intuition tells us. Very often, our painfully simple heuristic models (which you can learn or hear more about from Gerd Gigerenzer's speech, if you're a nerd like me) actually outperform very elegant statistical models. How can this be? The answer lies in this brilliant polemic from economist Robert Wenzel (which is almost as great as a similar recent rant from Jim Grant).
In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.
There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.
And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist.
Wenzel is dead on. We all know that models are useful, but they do not remove responsibility for rational risk management—only people have the power to do that. When callous risk managers at huge investment banks take another man's model on faith, and make huge bets with billions of dollars on the line without sanity-checking the model, that's nobody's fault but theirs.While my points were correct, I took a little while to get the point across. For a more pithy take on things, we'll turn to Barry Ritholtz, for this week's Quote of the Week.
This week's QUOTE OF THE WEEK
"Economists are neither Engineers nor Scientists, as each of these fields has a significant degree of precision in what they do, and test their hypotheses in a lab. The better choice for Economists are 'Historian' or 'Sociologists.' The sooner the profession loses its 'physics penis-envy', the better off we all will be."
- Blogger Barry Ritholtz
I'll just let that "physics penis-envy" line stand on its own, because I think it's the single greatest takedown of modern economics that I've ever seen.
As our economy becomes more and more dependent on the fantasy-land models put together on Ben Bernanke's laptop, I sincerely hope that the damage done by these grand experiments isn't so grave that we all end up suffering for decades. But if we allow ourselves to entrust ever more of our lives to these "scientists", we're certainly running that risk.