To Reduce Failures by Economists, They Should Think More Like Engineers

Posted on July 19th, 2009 by admin in Quant

The 16 July 09 issue of The Economist, a major international magazine, provides substantial analysis about improving the rather dystopic state of affairs of the economics profession in view of the financial calamity. But The Economist misses a key point about how to improve. We shall enlighten you, dear reader, but no one will like the solution, feasible though it is.

In the first, The Economist lead editorial sets the stage:

What went wrong with economics

It says:

“In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled. Though economists are still at the centre of the policy debate—think of Ben Bernanke or Larry Summers in America or Mervyn King in Britain—their pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.” “

We almost always find Krugman’s assessment of anything remotely political off-base or wacky, but he definitely gets it right, here!

Two other articles analyze the failures of economists to detect or clearly recover from the calamity. These two focus on various aspects of economic theory itself.

The other-worldly philosophers

Efficiency and beyond

The latter article has a nice discussion of the famous Efficient Markets Hypothesis, which is obviously bogus. I love the EMH! It says. all information that could affect the price of a stock is already incorporated into the price, so over time, no one can profit from investing. Don’t you love it?

The EMH is the source of the old joke about two economist walking together down the street. One sees a $20 bill on the ground and reaches to pick it up. Then the other economist stops him, and says “Hey, don’t bother-if that was a REAL $20 bill, someone would already have picked it up!”

One of themes coursing through these articles is that economists have used some important simplifying assumptions, such as EMH, to build their models. These models have worked fairly well. But just as in engineering, one has to consider the “corner cases” before accepting a model. Clearly, economists failed to consider a variety of corner cases, any one of which would have set off alarms about calamity. (A corner case is a situation in which an assumption takes an extreme value. For example, an economic corner case: credit stops flowing completely.)

OK, here is our addition to the post-mortem about economists: Economists need to learn that just because model building is very hard, it’s not a reason to avoid numerous, dirty details. Engineers build elegant, and sometimes ugly, theories. They strive to be elegant and as simple as feasible. They like to avoid complexity. But the engineering mission is to design and build stuff that works according to spec and costs no more than spec. Thus, they do whatever it takes to handle the details of reality.

We acknowledge up front that in the real world, engineers get real feedback, so they know how well their models work. But they also know how to use computers for some of the most beastly models. Just consider the modeling required to predict tomorrow’s weather (Al Gore pay attention). Major mainframe-level facilities are commonly used. Same thing for understanding airflow over a wing design, and how to connect 2 billion transistors to make a speedy CPU.

So, the message to the economics profession is: Life is tough, deal with it! Make models of really messy reality. Just because some social systems can be much more difficult to understand than various physical systems is not an excuse to choose simplicity when brute force of simulation of ugly factors would give better results.

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