Models and reality

30 Dec, 2021 at 13:36 | Posted in Economics | 8 Comments

One of the limitations with economics is the restricted possibility to perform experiments, forcing it to mainly rely on observational studies for knowledge of real-world economies.

But still — the idea of performing laboratory experiments holds a firm grip of our wish to discover (causal) relationships between economic ‘variables.’If we only could isolate and manipulate variables in controlled environments, we would probably find ourselves in a situation where we with greater ‘rigour’ and ‘precision’ could describe, predict, or explain economic happenings in terms of ‘structural’ causes, ‘parameter’ values of relevant variables, and economic ‘laws.’

Galileo Galilei’s experiments are often held as exemplary for how to perform experiments to learn something about the real world. Galileo’s heavy balls dropping from the tower of Pisa, confirmed that the distance an object falls is proportional to the square of time and that this law (empirical regularity) of falling bodies could be applicable outside a vacuum tube when e. g. air existence is negligible.

The big problem is to decide or find out exactly for which objects air resistance (and other potentially ‘confounding’ factors) is ‘negligible.’ In the case of heavy balls, air resistance is obviously negligible, but how about feathers or plastic bags?

One possibility is to take the all-encompassing-theory road and find out all about possible disturbing/confounding factors — not only air resistance — influencing the fall and build that into one great model delivering accurate predictions on what happens when the object that falls is not only a heavy ball but feathers and plastic bags. This usually amounts to ultimately state some kind of ceteris paribus interpretation of the ‘law.’

Another road to take would be to concentrate on the negligibility assumption and to specify the domain of applicability to be only heavy compact bodies. The price you have to pay for this is that (1) ‘negligibility’ may be hard to establish in open real-world systems, (2) the generalization you can make from ‘sample’ to ‘population’ is heavily restricted, and (3) you actually have to use some ‘shoe leather’ and empirically try to find out how large is the ‘reach’ of the ‘law.’

In mainstream economics, one has usually settled for the ‘theoretical’ road (and in case you think the present ‘natural experiments’ hype has changed anything, remember that to mimic real experiments, exceedingly stringent special conditions have to obtain).

In the end, it all boils down to one question — are there any Galilean ‘heavy balls’ to be found in economics, so that we can indisputably establish the existence of economic laws operating in real-world economies?

As far as I can see there are some heavy balls out there, but not even one single real economic law.

Economic factors/variables are more like feathers than heavy balls — non-negligible factors (like air resistance and chaotic turbulence) are hard to rule out as having no influence on the object studied.

Galilean experiments are hard to carry out in economics, and the theoretical ‘analogue’ models economists construct and in which they perform their ‘thought-experiments’ build on assumptions that are far away from the kind of idealized conditions under which Galileo performed his experiments. The ‘nomological machines’ that Galileo and other scientists have been able to construct have no real analogues in economics. The stability, autonomy, modularity, and interventional invariance, that we may find between entities in nature, simply are not there in real-world economies. That’s are real-world fact, and contrary to the beliefs of most mainstream economists, they won’t go away simply by applying deductive-axiomatic economic theory with tons of more or less unsubstantiated assumptions.

By this, I do not mean to say that we have to discard all (causal) theories/laws building on modularity, stability, invariance, etc. But we have to acknowledge the fact that outside the systems that possibly fulfill these requirements/assumptions, they are of little substantial value. Running paper and pen experiments on artificial ‘analogue’ model economies is a sure way of ‘establishing’ (causal) economic laws or solving intricate econometric problems of autonomy, identification, invariance and structural stability — in the model world. But they are pure substitutes for the real thing and they don’t have much bearing on what goes on in real-world open social systems. Setting up convenient circumstances for conducting Galilean experiments may tell us a lot about what happens under those kinds of circumstances. But — few, if any, real-world social systems are ‘convenient.’ So most of those systems, theories and models, are irrelevant for letting us know what we really want to know.

To solve, understand, or explain real-world problems you actually have to know something about them — logic, pure mathematics, data simulations or deductive axiomatics don’t take you very far. Most econometrics and economic theories/models are splendid logic machines. But — applying them to the real world is a totally hopeless undertaking! The assumptions one has to make in order to successfully apply these deductive-axiomatic theories/models/machines are devastatingly restrictive and mostly empirically untestable– and hence make their real-world scope ridiculously narrow. To fruitfully analyze real-world phenomena with models and theories you cannot build on patently and known to be ridiculously absurd assumptions. No matter how much you would like the world to entirely consist of heavy balls, the world is not like that. The world also has its fair share of feathers and plastic bags.

Most of the ‘idealizations’ we find in mainstream economic models are not ‘core’ assumptions, but rather structural ‘auxiliary’ assumptions. Without those supplementary assumptions, the core assumptions deliver next to nothing of interest. So to come up with interesting conclusions you have to rely heavily on those other — ‘structural’ — assumptions.

Economic models frequently invoke entities that do not exist, such as perfectly rational agents, perfectly inelastic demand functions, and so on. As economists often defensively point out, other sciences too invoke non-existent entities, such as the frictionless planes of high-school physics. But there is a crucial difference: the false-ontology models of physics and other sciences are empirically constrained. If a physics model leads to successful predictions and interventions, its false ontology can be forgiven, at least for instrumental purposes – but such successful prediction and intervention is necessary for that forgiveness. The
idealizations of economic models, by contrast, have not earned their keep in this way. So the problem is not the idealizations in themselves so much as the lack of empirical success they buy us in exchange. As long as this problem remains, claims of explanatory credit will be unwarranted.

A. Alexandrova & R. Northcott

In physics, we have theories and centuries of experience and experiments that show how gravity makes bodies move. In economics, we know there is nothing equivalent. So instead mainstream economists necessarily have to load their theories and models with sets of auxiliary structural assumptions to get any results at all in their models.

So why then do mainstream economists keep on pursuing this modeling project?

Mainstream ‘as if’ models are based on the logic of idealization and a set of tight axiomatic and ‘structural’ assumptions from which consistent and precise inferences are made. The beauty of this procedure is, of course, that if the assumptions are true, the conclusions necessarily follow. But it is a poor guide for real-world systems. As Hans Albert has it on this ‘style of thought’:

A theory is scientifically relevant first of all because of its possible explanatory power, its performance, which is coupled with its informational content …

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 …

The way axioms and theorems are formulated in mainstream economics often leaves their specification without almost any restrictions whatsoever, safely making every imaginable evidence compatible with the all-embracing ‘theory’ — and theory without informational content never risks being empirically tested and found falsified. Used in mainstream ‘thought experimental’ activities, it may, of course, ​be very ‘handy,’ but totally void of any empirical value.

Some economic methodologists have lately been arguing that economic models may well be considered ‘minimal models’ that portray ‘credible worlds’ without having to care about things like similarity, isomorphism, simplified ‘representationality’ or resemblance to the real world. These models are said to resemble ‘realistic novels’ that portray ‘possible worlds’. And sure: economists constructing and working with that kind of models learn things about what might happen in those ‘possible worlds’. But is that really the stuff real science is made of? I think not. As long as one doesn’t come up with credible export warrants to real-world target systems and show how those models — often building on idealizations with known to be false assumptions — enhance our understanding or explanations about the real world, well, then they are just nothing more than just novels.  Showing that something is possible in a ‘possible world’ doesn’t give us a justified license to infer that it therefore also is possible in the real world. ‘The Great Gatsby’ is a wonderful novel, but if you truly want to learn about what is going on in the world of finance, I would recommend rather reading Minsky or Keynes and directly confront real-world finance.

Different models have different cognitive goals. Constructing models that aim for explanatory insights may not optimize the models for making (quantitative) predictions or deliver some kind of ‘understanding’ of what’s going on in the intended target system. All modeling in science have tradeoffs. There simply is no ‘best’ model. For one purpose in one context model A is ‘best’, for other purposes and contexts model B may be deemed ‘best’. Depending on the level of generality, abstraction, and depth, we come up with different models. But even so, I would argue that if we are looking for what I have called ‘adequate explanations’ (Syll, Ekonomisk teori och metod, Studentlitteratur, 2005) it is not enough to just come up with ‘minimal’ or ‘credible world’ models.

The assumptions and descriptions we use in our modeling have to be true — or at least ‘harmlessly’ false — and give a sufficiently detailed characterization of the mechanisms and forces at work. Models in mainstream economics do nothing of the kind.

Coming up with models that show how things may possibly be explained is not what we are looking for. It is not enough. We want to have models that build on assumptions that are not in conflict with known facts and that show how things actually are to be explained. Our aspirations have to be more far-reaching than just constructing coherent and ‘credible’ models about ‘possible worlds’. We want to understand and explain ‘difference-making’ in the real world and not just in some made-up fantasy world. No matter how many mechanisms or coherent relations you represent in your model, you still have to show that these mechanisms and relations are at work and exist in society if we are to do real science. Science has to be something more than just more or less realistic ‘story-telling’ or ‘explanatory fictionalism.’ You have to provide decisive empirical evidence that what you can infer in your model also helps us to uncover what actually goes on in the real world. It is not enough to present your students with epistemically informative insights about logically possible but non-existent general equilibrium models. You also, and more importantly, have to have a world-linking argumentation and show how those models explain or teach us something about real-world economies. If you fail to support your models in that way, why should we care about them? And if you do not inform us about what are the real-world intended target systems of your modeling, how are we going to be able to value or test them? Without giving that kind of information it is impossible for us to check if the ‘possible world’ models you come up with actually hold also for the one world in which we live — the real world.

8 Comments

  1. Kingsley, aren’t Borio, Macauley et al. assuming costs that they cannot point to in this well-known paper, like imagining an aether, to save their economic law of no arbitrage conditions? In other words, is their argument that unobserved “balance sheet costs” must save economic no-arbitrage laws, because otherwise prices become arbitrary and that is simply too cognitively dissonant for these economists to stomach?
    .
    Does the following more recent paper find (again, unobservable) dealer costs to be the main culprit, but is their description of “cost” indistinguishable from markup?
    .
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3970130
    .
    In any case, even if you assume unobservable costs due to regulatory constraints, aren’t observed FX swaps still arbitrary as they exist today, because money dealers can choose whatever markup they feel like and know they have a risk-free trade? Even if regulations are causing CIP violation, don’t we still live in a world where money dealers have guaranteed free-lunch trades available to them?
    .
    Further, are a lot of rational pricing formulas explicitly based on CIP, thus its violation makes those formulas yield negative prices in many cases?
    .
    Are mainstream economists still struggling to understand this glaring “elephant in the room” violation of no-arbitrage asdumptions, much as physicists struggle to incorporate observations of gravity law violations in galactic rotation curves, and observations of accelerating universe expansion?
    .
    Back to Dr. Saeidinezhad’s recent paper linked above, does his dismissal of the argument presented in Borio, et al.’s older paper (see page 13 for criticism of Borio’s “academic” approach to derivative pricing) indicate the degree to which mainstream economists still trusting in laws about no free lunches disagree with each other about what is causing the blatantly observable violation of all such laws? (Again, similar to how dark energy and dark matter, accounting for 96% of the observed universe, violate standard physics laws?)

    • @rsm
      There is no free lunch to be gained from arbitrage, trading, gambling or playing in any market, including FX markets, because these activities require finance.
      In an uncertain world there are constraints on the supply of finance for all traders (including your “money dealers”).
      Financial constraints imply costs (or opportunity costs) of finance > zero, hence there is no free lunch.
      .
      You suggest that the paper by Borio et al. is unsound because the costs of financial constraints are “unobservable”.
      However, you can gain a better understanding of these costs and experience them yourself if you try to get a big bank loan in order to play the FX markets and make $millions.
      Doubtless your bank manager will be able to explain the high interest rates required for financing risky projects, the costs of getting collateral, the costs and miseries of bankruptcy, and/or the cost of insurance against losses.
      .
      Maybe then you will appreciate the empirical economic law that “There is no such thing as a free lunch”.

    • Kingsley, did you neglect to consider that no-arbitrage conditions are a necessary condition for rational pricing theory, because if arbitrage conditions persist, fair pricing formulas can yield negative prices? Thus, are you agreeing with me that prices cannot be proven non-arbitrary?
      .
      What if I got a state chartered bank to get loans from the Fed at 0.10% and use carry trades to generate risk-free arbitrage profits? If I have enough assets (state tax revenue and other assets such as rainy-day funds, etc.), will the bank manager sing a different tune than what you predict? Is the FX free lunch trade self-insuring, requiring no separate insurance, hence its designation as “risk-free”?
      .
      In the paper by Saeidinezhad linked in another comment, the following passage appears, on page 38:
      .
      《the dealers are adjusting their spreads for non-regulatory causes. Specifically, the swap dealers have started to align their market-making incentives with shareholders’ interest than the provision of market liquidity. This practice is known as funding value adjustments (FVAs). It is equal to the debt-overhang costs to the shareholders^40. The idea is that reaching the debt-overhang point will force the dealers to deleverage and use their capital to continue market making. This practice is expensive for the shareholders, as it limits their return on equity. As a result, FX swap dealers, often large publicly-traded banks, have started to factor “shareholders financing costs” into their prices^41. As a form of variable cost, the inclusion of shareholders’ interest impacts dealers’ swap valuation and swap rate quotation》
      .
      But isn’t this simply markup? If I’m willing to accept 25 basis points profit, can I get it, risk-free, in FX swap markets? If I’m a big firm and leave that money on the table, can’t another big firm close that arbitrage to preserve rational pricing theory? But if not enough firms want to accept a risk-free trade, does that mean that those who do can set their markup to satisfy whatever their shareholders will accept?
      .
      Are you so blinded by the assumption that there is no free lunch, that you deny an obvious free lunch because some firms that should be hungry for profits leave that free lunch on the table because they’re getting bigger lunches elsewhere? But does the free lunch represented by the negative cross currency basis still sit there available to those firms that feel like taking it?

      • @rsm
        Why can’t you simply tell us the honest truth?
        What did your bank manager say when you asked him for a big loan in order to get a free lunch from trading on the FX market?
        How much money did you lose net of the finance costs?
        How did you escape from bankruptcy?

  2. Lars said “In physics, we have theories and centuries of experience and experiments that show how gravity makes bodies move.” But does the best physics gravity model fail to predict the movements of the largest bodies we can see, unless you posit an aether-like dark matter?
    .
    Kingsley said: “There is no such thing as a free lunch.” But does the continued, persistent observed violation of Covered Interest Parity provide clear evidence of free lunches in the voluminous currency swap market? If arbitrage conditions on a huge scale can exist indefinitely, does that undermine half of the economic laws listed in Kingsley’s post? Has rational pricing theory been disproved by CIP violation?

    • Relevant conomic laws generally hold because of “the combination of hedging demand and tighter limits to arbitrage, which in turn reflect a tighter management of risks and bank balance sheet constraints”.
      https://www.bis.org/publ/qtrpdf/r_qt1609e.htm

  3. Prof Syll suffers from chronic myopia. As in numerous previous posts, he says:
    “As far as I can see there is not even one single real economic law.”
    .
    Symptoms of Prof Syll’s myopia are:
    – Blinkered focus on DSG modeling and general equilibrium theorizing which are minor and fruitless parts of economics.
    .
    – Hallucinations that economists try to derive laws from “deductive-axiomatic theories/models/machines which are devastatingly restrictive and mostly empirically untestable”.
    .
    – Reluctance to fully recognize that all scientific laws are to varying degrees probablistic, conditional and temporary. Moreover laws may be concerned with tendencies rather than certainties or ultimate end states. See Marshall – Principles of Economics, Bk I, chapter III: ‘Economic Generalizations or Laws’.
    .
    – Denial that there are many thousands of economic laws. These include some laws formulated by economists and an even greater number embodied in common sense, popular culture and literature.
    .
    EXAMPLES OF LAWS FORMULATED BY ECONOMISTS
    ——————————————————————–
    – Engel’s law:
    As family income increases, the percentage of income spent on food decreases.

    -Keynes’ “fundamental psychological law”:
    ”Men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income”.

    Iron Law of Wages:
    In the long run wages tend the cost of just enough of food, clothing and shelter to maintain existence in the absence of family planning, wars, epidemics and/or increases in the demand for labor due to technical progress or government economic policies.

    The Law of Substitution (a special and limited application of the law of survival of the fittest):
    “One method of industrial organization tends to supplant another when it offers a direct and immediate service at a lower price.”
    Marshall – Principles of Economics, Bk VI chapter VII: ‘Profits of Capital and Business Power’.

    The law of Increasing Returns to Scale:
    “In those industries which are not engaged in raising raw produce, an increase of labour and capital generally gives a return increased more than in proportion.”
    Marshall – Principles of Economics, Bk IV chapter XII

    – Law of Diminishing Returns:
    “During a short period of time an increase in the amount demanded raises the normal supply price. This law is almost universal even as regards industries which in long periods follow the tendency to increasing return.”
    Marshall – Principles of Economics, Bk V chapter V
    .
    Law of Supply and Demand:
    “When the demand price is equal to the supply price, the amount produced has no tendency either to be increased or to be diminished; it is in equilibrium. … if any accident should move the scale of production from its equilibrium position, there will be instantly brought into play forces tending to push it back to that position.”
    Marshall – Principles of Economics, Bk V chapter III

    EXAMPLES OF ECONOMIC LAWS EMBODIED IN COMMON SENSE, POPULAR CULTURE AND LITERATURE
    ———————————————————————————————-
    – Rome wasn’t built in a day
    (Success in business takes time and effort)
    .
    – There is no such thing as a free lunch
    – You can’t get owt for nowt
    – No pain, no gain
    (All goods have an opportunity cost because scarce resources are needed to produce them)
    .
    – “There be three things which make a nation great and prosperous: a fertile soil, busy workshops, easy conveyance for men and goods from place to place”
    Francis Bacon (1561–1626)
    .
    – The community does not exist on the fictitious value of money but on the results of productive labour, which is what gives money its value.
    Adolf Hitler, speech to the German Reichstag, January 30, 1937
    .
    – Mighty oaks from little acorns grow
    (All businesses start small)
    .
    – Nothing ventured, nothing gained.
    – Fortune follows the brave. Audentis Fortuna iuvat (Virgil)
    (Earning profits requires taking risks)
    .
    – Make hay while the sun shines
    (Success is more likely if you take advantage of favorable opportunities) 
    .
    The early bird gets the worm.
    (Early well prepared entrants into new markets face less competition and make more profits than late entrants)
    .
    – Don’t throw good money after bad
    – Let bygones be bygones
    (Don’t commit the sunk costs fallacy – unrecoverable costs should not influence current decision-making)
    .
    – Penny wise, pound foolish
    – A stitch in time saves nine
    (Making economies today, eg cutting spending on maintenance, may lead to substantial future costs which should not be neglected)
    .
    – Take care of the pence, and the pounds will take care of themselves
      (Numerous small gains may be more advantageous than a few big items)
    .
    – If it is too good to be true it probably isn’t.
    (Extremely high returns are very unlikely)
    .
    – A fool and his money are soon parted
    .
    – No money, no honey
    .
    – Money begets money.
    .
    -Money, like manure, does no good till it is spread.
    .
    – Money borrowed is soon sorrowed
    – Money often costs too much. (Emerson)
    – Neither a lender nor a borrower be, for loan oft loses both itself and friend, and borrowing dulls the edges of husbandry. (Polonius’ advice to his son in Shakespeare’s play ‘Hamlet’)
    .
    – Money calls, but does not stay: It is round and rolls away.    
    .
    – Money is a good servant, but a dangerous master (Francis Bacon)
    .
     – Money never made a man happy yet, nor will it. There is nothing in its nature to produce happiness. The more a man has, the more he wants. (Ben. Franklin.)
    .
    – The love of money is the root of all evil (I Timothy 6:10)
    – Money is the fruit of evil as often as the root of it (Henry Fielding)
    .
    Credit is the lifeblood of business, the lifeblood of prices and jobs.
    President Herbert Hoover (1874–1964), address at Des Moines, Iowa, October 4, 1932
    .
    The best way to destroy the capitalist system is to debauch the currency.
    Attributed to Vladimir Ilich Lenin by John Maynard Keynes, The Economic Consequences of the Peace, p. 235 (1920) [However, as Keynes noted, this quotation has not been found in Lenin’s writings and remains unverified].
    .
    – The appropriation of public money always is perfectly lovely until some one is asked to pay the bill … Nothing is easier than spending the public money. It does not appear to belong to anybody. The temptation is overwhelming to bestow it on somebody.
    Calvin Coolidge (1872–1933)
    .
    – The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, assistance to foreign lands should be curtailed lest Rome become bankrupt, the mobs should be forced to work and not depend on government for subsistence.
    Spuriously attributed to Marcus Tullius Cicero (106-43 BCE)

    • SyringeSyringe Dr Henry Madison
      @RageSheen
      A short thread on the magnitude of public maladministration in Australia in the past 50 years, driven by libertarian populists in more recent times and more general neoliberal ideas prior to that. And how Covid throws this disaster into stark relief. /1 #COVID19Aus #auspoll

      Basically private debt replaced government investment and with it any public/democratic administration.


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