Why Economic Models Consistently Fail: NeoClassical vs. Austrian Views

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Why Economic Models Consistently Fail: NeoClassical vs. Austrian Views

Why Economic Models Consistently Fail: NeoClassical vs. Austrian Views

Before I start, I want to say that I have not read Mises, Hayek, or Rothbard.  I arrived at these conclusions on my own.  I also want to quote Buffett:

“It is better to be approximately right, than precisely wrong.”

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Applying math to economics has been a loser.  Who has a consistently good macroeconomic model?  No one that I know has ever devised one. Estimates of future GDP growth and inflation are regularly wrong, and no one calls turning points well.

Even microeconomic models are in bad shape; most of the major hypotheses get rejected when doing general equilibrium tests.

Why? Because capitalistic economies are more dynamic than mathematical models can mirror.  Live with the volatility, and don’t try to model it.  We face the same in the asset markets, behavior is not predictable.

Austrian economics understands the boom-bust cycle.  Neoclassical economics assumes we move to an equilibrium.  Have you ever lived in an equilibrium?  There is never an equilibrium, or it is always unstable, and that is the beauty of Austrian economics.  The lack of an equilibrium means the system is always adjusting, it does not rest.

Why do neoclassical economists assume equilibrium?  The obvious reason is to make their stupid math work.  It is the same for guys in finance.  Why do they assume normality;  to make their stupid math work.  The world is complex, but the economists assume that it is not complex, in order to make their models work.

Bias

There is a bias that exists below the surface of all macroeconomic commentary.  Do we look at the income statement, or do we look at the balance sheet?  Neoclassical economists mostly look at the income statement.  Austrian economists look at the balance sheet.  (Neoclassical economists are friends with growth investors, Austrians are friends of value investors.)

Think of the “brick through the window” fallacy.  On the Neoclassical version of GDP, a brick through the window raises GDP.  The Austrians are smarter, and realize that the change in aggregate net wealth is negative.

Neoclassical economics believed debt levels were neutral and were proven wrong in the recent crisis.  They did not look at the balance sheet.

Neoclassical economists, who have dominated the Fed for over 40 years, drove us into a huge inflation, which Volcker choked, and then Greenspan & Bernanke drove us into a liquidity trap, by refusing to let recessions eliminate bad debt, creating the “great moderation,” which is now known as a sham.

What You Can’t Quantify Well

Quantitative economics has not improved understanding.  Ben Bernanke flies blind, but claims that he sees; the Fed has been a lousy predictor of economic outcomes, despite the legion of academic economists they employ.  There are no economists that have consistently forecast the economy well.

That’s why I don’t agree with those that criticize Austrian economics for avoiding quantifying their theories.  Economics is not a science; it does not quantify well, at least in detail.

Economics should be primarily an ethical discipline.  The government is a referee, rather than an overlord.  The government should assure equality of opportunity, rather than equality of result.

It’s not as if the government can use its “policy levers” to create any degree of lasting prosperity.  Prosperity lies within the control of individuals who apply their acumen to the situation, and come up with creative ways of meeting human needs.

Closing

Thus, I don’t have much sympathy for those that reject Austrian economics because we don’t have a mathematical means of expressing it.  Paraphrasing the Buffett quote, “I would rather be approximately right than precisely wrong.”  There are many things that I don’t have an exact economic model for, but that I do know a decent amount about.  Qualitative knowledge is valuable, and should not be disrespected by those that do not have a better model, such as the broken model of the neoclassical economists.

By: alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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