The perils of using Mickey Mouse models

10 July, 2017 at 10:02 | Posted in Economics | 1 Comment

When mainstream economists comment on the status of the Efficient Market Hypothesis, the really interesting questions as a rule drown in the usual pseudo science mumbo jumbo of four-factor models with two mispricing factors being better-performing than three-factor models, etc., etc.

Better read what Diane Coyle has to say about it:

I would defend using the assumption of rational choice as long as one realises that it is not a description of reality.

But there is one area where for 30 years economists – and others – have been making that mistake. That is unfortunately, of course, in the financial markets. Practitioners and policy makers acted as if the strong form of the Efficient Markets Hypothesis held true – in other words that prices instantly reflect all relevant information about the future – even though this evidently defies reality …

spock_in_2012_by_rabittooth-d4p2io9I think an honest conventionally-trained economist has to at least acknowledge that we grew intellectually lazy about this. Although we all knew at some level that the rational choice assumption was being made to bear too much weight, very few economists openly challenged its everyday use in justifying public policy decisions. Very few of us put this weight on it in our own work. But not all that many economists challenged its pervasive use in the public policy world …

The financial and economic crisis also spells a crisis for certain areas of economics, or approaches to economics. Financial economics and macroeconomics are particularly vulnerable. They are the subject areas where the consequences of the standard assumptions have been most damaging, because they are actually least valid. Financial market traders are not remotely like Star Trek’s Mr Spock, making rational calculations unaffected by emotion or by the decisions of other people. Macroeconomics – the study of how millions of individual decisions aggregate into economy-wide measures – is essentially ideological. How macroeconomists answer a question like ‘What will be the effect of cutting the budget deficit on growth next year?’ depends on their political views. This is not remotely a scientific area of the discipline. The consensus about macroeconomics during what’s been described as ‘the Great Moderation’ of the 1990s has entirely broken down.

Diane Coyle

The Efficient Market Hypothesis assumes — with no supporting evidence — that all information relevant to the pricing of financial assets is known by all market participants. That also implies having all relevant information on all future returns on those assets. If reality was like that it would be great. But it’s not. The future is uncertain. Forgetting that, and instead building models on ridiculous assumptions like rational expectations and efficient markets, Chicago style economists produce Mickey Mouse models of our economies.

Mickey Mouse modeling is for kids. It’s not science.

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1 Comment

  1. I think finance has figured out how to relax the constraints of neoclassicalism. Finance can use linear algebra optimization to find the solution to Ax = b, where A is a matrix of all stock prices and their future states, b is your desired profit, and x is the trades you make on A to get b. Hence, riskless profit on arbitrary price movements.

    Prices can be arbitrary, contrary to the Efficient Market Hypothesis, and quants can make money by using linear algebra to account for every possible outcome and still guarantee you a profit.


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