Economics and models

The development of mental models is one of the most important ways through which we make sense of the world around us. That’s true of everything from the earth orbiting the sun to the internal workings of a jet engine, and from the maps that help us navigate to our political systems. When we have good models, we call them scientific and, when we don’t, we think in terms of belief and ideology. When we share a common model, it is easy to debate how to improve the model, and when we don’t we tend to struggle to make any advances.

The image of the world around us, which we carry in our head, is just a model. Nobody in his head imagines all the world, government or country. He has only selected concepts, and relationships between them, and uses those to represent the real system.
Jay Wright Forrester

In order to work out what is wrong with economics, and economists, I wanted to understand the mental models that economists use to drive their thinking. What does the economy look like? Who are the main participants e.g. banks, businesses, households? How do they interact with each other?

When I looked for this type of insight, one of the first surprises I found was that economists seem to make little use of diagrams. Although this might seem trivial, it means that it is very difficult for a layman to envisage how economists picture the economy, why they expect a particular policy change to improve the economy, or how the view of one economist differs from that of another.

A picture is worth a thousand words, except in economics.
Jamie

A verbal description is the next best option. The economics profession set up the Institute for New Economic Thinking (INET) to promote novel ideas following the advent of the current economic crisis. It held an inaugural conference, attended by many of the world’s leading economists, in April 2010. At this conference, Joseph Stiglitz gave an excellent presentation (including 23 slides with, of course, no diagrams) where he discussed many of the limitations of the models and methodologies used by mainstream economists prior to the crisis. He also proposed some areas for research to improve these models. Here are just a few key points.

Stiglitz began by discussing some of the mainstream economic beliefs which had turned out to be wrong. One of these was incredible.

There is no such thing as a bubble.
The mainstream economics profession

Now, bubbles have been known since Tulip Mania in the 1630s, and the Internet bubble burst only a few years before the current crisis. As a result, this statement, on its own, seems to be sufficient evidence to discredit the entire mainstream economics profession.

Stiglitz then discussed some of the assumptions that mainstream economists use in their models. These include an assumption that all people are identical and can be modelled as a single representative agent, and a further assumption of rational expectations which suggests that the representative agent always behaves rationally and with perfect information on the state of the economy. Again, these statements seem to discredit the entire profession. As Stiglitz indicated, if there is a single representative agent then how do financial markets work e.g. who sells to whom, who lends to whom, how can bankruptcies happen, who causes a run on the stock market? Most importantly, these assumptions preclude the current crisis.

One of Stiglitz’s main overall points was that there is no possibility of interactions between agents in these models. He concluded that one of the biggest modelling challenges for the profession is the inclusion of various types of interaction. These include regulation and control interactions as well as the transactional interactions which drive markets.

One of my initial observations on this blog concerned double pendulums. A single pendulum is the equivalent of the economic vision of a rational agent with very predictable behaviour. A single pendulum has perfect information on the influence of gravity on its behaviour. However, when two pendulums interact, the resultant system can produce unpredictable and unstable behaviour. It seems that the vast majority of the economics profession is oblivious to this type of behaviour.

Taking these points together, the pre-crisis economics profession resembles a religious cult more than a group of professional experts investigating the behaviour of a complex system. At the very least, they come across as a closed community with limited ability to draw analogies, and inspiration, from similar fields of study such as meteorology. As a pseudo-scientific endeavour, pre-crisis mainstream economics resembles a modern equivalent of alchemy.