Do unrealistic economic models explain real-world phenomena?

22 November, 2015 at 15:14 | Posted in Economics | 1 Comment

When applying deductivist thinking to economics, neoclassical economists usually set up “as if” models based on a set of tight axiomatic assumptions from which consistent and precise inferences are made. The beauty of this procedure is of course that if the axiomatic premises are true, the conclusions necessarily follow. idealization-in-cognitive-and-generative-linguistics-6-728The snag is that if the models are to be relevant, we also have to argue that their precision and rigour still holds when they are applied to real-world situations. They often don’t. When addressing real economies, the idealizations and abstractions necessary for the deductivist machinery to work simply don’t hold.

If the real world is fuzzy, vague and indeterminate, then why should our models build upon a desire to describe it as precise and predictable? The logic of idealization is a marvellous tool in mathematics and axiomatic-deductivist systems, but a poor guide for action in real-world systems, in which concepts and entities are without clear boundaries and continually interact and overlap.

Or as Hans Albert has it on the neoclassical style of thought:

In everyday situations, if, in answer to an inquiry about the weather forecast, one is told that the weather will remain the same as long as it does not change, then one does not normally go away with the impression of having been particularly well informed, although it cannot be denied that the answer refers to an interesting aspect of reality, and, beyond that, it is undoubtedly true …

We are not normally interested merely in the truth of a statement, nor merely in its relation to reality; we are fundamentally interested in what it says, that is, in the information that it contains …

Information can only be obtained by limiting logical possibilities; and this in principle entails the risk that the respective statement may be exposed as false. It is even possible to say that the risk of failure increases with the informational content, so that precisely those statements that are in some respects most interesting, the nomological statements of the theoretical hard sciences, are most subject to this risk. The certainty of statements is best obtained at the cost of informational content, for only an absolutely empty and thus uninformative statement can achieve the maximal logical probability …

hans_albertThe neoclassical style of thought – with its emphasis on thought experiments, reflection on the basis of illustrative examples and logically possible extreme cases, its use of model construction as the basis of plausible assumptions, as well as its tendency to decrease the level of abstraction, and similar procedures – appears to have had such a strong influence on economic methodology that even theoreticians who strongly value experience can only free themselves from this methodology with difficulty …

Science progresses through the gradual elimination of errors from a large offering of rivalling ideas, the truth of which no one can know from the outset. The question of which of the many theoretical schemes will finally prove to be especially productive and will be maintained after empirical investigation cannot be decided a priori. Yet to be useful at all, it is necessary that they are initially formulated so as to be subject to the risk of being revealed as errors. Thus one cannot attempt to preserve them from failure at every price. A theory is scientifically relevant first of all because of its possible explanatory power, its performance, which is coupled with its informational content …

The connections sketched out above are part of the general logic of the sciences and can thus be applied to the social sciences. Above all, with their help, it appears to be possible to illuminate a methodological peculiarity of neoclassical thought in economics, which probably stands in a certain relation to the isolation from sociological and social-psychological knowledge that has been cultivated in this discipline for some time: the model Platonism of pure economics, which comes to expression in attempts to immunize economic statements and sets of statements (models) from experience through the application of conventionalist strategies …

Clearly, it is possible to interpret the ‘presuppositions’ of a theoretical system … not as hypotheses, but simply as limitations to the area of application of the system in question. Since a relationship to reality is usually ensured by the language used in economic statements, in this case the impression is generated that a content-laden statement about reality is being made, although the system is fully immunized and thus without content. In my view that is often a source of self-deception in pure economic thought …

A further possibility for immunizing theories consists in simply leaving open the area of application of the constructed model so that it is impossible to refute it with counter examples. This of course is usually done without a complete knowledge of the fatal consequences of such methodological strategies for the usefulness of the theoretical conception in question, but with the view that this is a characteristic of especially highly developed economic procedures: the thinking in models, which, however, among those theoreticians who cultivate neoclassical thought, in essence amounts to a new form of Platonism.

Seen from a deductive-nomological perspective, typical economic models (M) usually consist of a theory (T) – a set of more or less general (typically universal) law-like hypotheses (H) – and a set of (typically spatio-temporal) auxiliary conditions (A). The auxiliary conditions (assumptions) give “boundary” descriptions such that it is possible to deduce logically (meeting the standard of validity) a conclusion (explanandum) from the premises T & A. Using this kind of model economists are (portrayed as) trying to explain (predict) facts by subsuming them under T given A.

This account of theories, models, explanations and predictions does not — of course — give a realistic account of actual scientific practices, but rather aspires to give an idealized account of them.

An obvious problem with the formal-logical requirements of what counts as H is the often severely restricted reach of the “law”. In the worst case it may not be applicable to any real, empirical, relevant situation at all. And if A is not true, then M doesn’t really explain (although it may predict) at all. Deductive arguments should be sound – valid and with true premises – so that we are assured of having true conclusions. Constructing, e.g., models assuming ‘rational’ expectations, says nothing of situations where expectations are ‘non-rational.’

Most mainstream economic models are abstract, unrealistic and presenting mostly non-testable hypotheses. How then are they supposed to tell us anything about the world we live in?

When confronted with the massive empirical refutations of almost every theory and model they have set up, mainstream economists usually react by saying that these refutations only hit A (the Lakatosian “protective belt”), and that by “successive approximations” it is possible to make the theories and models less abstract and more realistic, and – eventually — more readily testable and predictably accurate. Even if T & A1 doesn’t have much of empirical content, if by successive approximation we reach, say, T & A25, we are to believe that we can finally reach robust and true predictions and explanations.

There are grave problems with this modeling view. What Hans Albert most forcefully is arguing with his “Model Platonism” critique of mainstream economics, is that there is a tendency for modelers to use the method of successive approximations as a kind of “immunization,” taking for granted that there can never be any faults with the theory. Explanatory and predictive failures hinge solely on the auxiliary assumptions. That the kind of theories and models used by mainstream economics should all be held non-defeasibly corrobated, seems, however — to say the least — rather unwarranted.

Confronted with the massive empirical failures of their models and theories, mainstream economists often retreat into looking upon their models and theories as some kind of “conceptual exploration,” and give up any hopes/pretenses whatsoever of relating their theories and models to the real world. Instead of trying to bridge the gap between models and the world, one decides to look the other way.

To me this kind of scientific defeatism is equivalent to surrendering our search for understanding the world we live in. It can’t be enough to prove or deduce things in a model world. If theories and models do not directly or indirectly tell us anything of the world we live in – then why should we waste any of our precious time on them?


1 Comment

  1. What Hans Albert, in the passage quoted, seems to me to be getting at might be exemplified by the importance of null results in economics. In the doctrine of modern financial economics, for example, many of the foundational results are null results. For example, the Modigliani–Miller theorem is such a null result. Quoting Wikipedia, “The basic theorem states that . . . in an efficient [capital] market, the value of a firm is unaffected by how that firm is financed.” The logical reasoning behind this result requires little more than high school algebra, and it strikes many as counter-intuitive, though the basic intuition behind the result is simple and straightforward.
    To increase the force of my argument, I am going to explain the basic intuition, as it should make clear just how persuasive is this famous result. The intuition is based on the supposition that the firm’s productive business operations generate the economic value of the firm, and for financial purposes, this economic value is reflected in the expected cash flow from those business operations, presumably making and selling goods of some kind. Finance is concerned not with the operations of the firm, but with its capital structure — that is, with determining how the cash flow is to be divided among claimants: so much for trade creditors, so much for bond holders, the remainder for the owners, i.e., the holders of common stock. Each of these claims on future cash flow, itself, has a market asset value. The trade creditors could sell their receivables; the bond holders could trade their bonds; the stockholders can sell their stock. The total expected cash flow from the business in the future is uncertain, and the risk associated with these differing claims varies systematically: the trade creditors have very strong claims to being paid a fixed and determinate amount or being able to recover goods of equivalent value; the stock holders, on the other hand, have only a residual claim, payable after other creditors have been satisfied. In the event that the realized total cash flow is high, the stockholders have, as they say, a big upside; the trade creditors and bondholders do not share in that “upside”.
    Modigliani-Miller rests on the “insight”, if we can call it that, that nothing about capital structure actually alters the productive operations of the firm, actually alters the total expected cash flow. Assuming no one is being defrauded or fooled, then the financial pieces — the value of the individual cash flow claims of various stakeholders — should equal the value of the total cash flow. The parts can be no more valuable than the whole.
    It is counter-intuitive, especially for the bankers and executives, who work quite assiduously designing and manipulating capital structures, as part of the business of financing operations, that their work does nothing to enhance the value of the firm. It is, I think most would agree, undoubtedly true. It seems to say something important about a matter of practical interest. (Just as Hans Albert says in general terms about this style of thought.)
    But, it is, as I call it, a null result. There’s no information content. It becomes a touchstone for those building their so-called expertise in financial economics. But, it doesn’t actually tells anything about capital structure, beyond suggesting that capital structures are irrelevant. In fact, Wikipedia helpfully informs us that this theorem is commonly called, “capital structure irrelevance principle”.
    I offer this example in the spirit of knowing one’s enemy. Modigliani–Miller may be as good as neoclassical economics gets. It is not wrong, and it is not unimportant. It knocked down ill-considered intuitions back in the day, and it shows the very real and persuasive power of logical analysis — I should think what should be the undoubted power of logical analysis. It also leaves the real world of finance and capital structure untouched and unexplained — it is a null result.
    The lesson, here, is that logical analysis is not enough. It is necessary, I think. I don’t see much merit in rejecting logical rigor, per se. To know something of the world, it is necessary to look at the world and interact with the world. It is not sufficient to speculate in isolation. Economics needs more than idle and ill-conceived speculation to move forward.

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