A Model’s Got to Know Its Limitations

By August 1, 2013 No Comments


One of the things that drew me into economics was a completely different way of looking at the world. Having multiple methods for examining a problem is enormously powerful, and an essential ingredient to developing worldly wisdom. Warren Buffet’s offsider Charles Munger says it well:

The first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine. It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” And of course, that’s the way the chiropractor goes about practising medicine. But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you’ve got to have multiple models.

Around the world, central banks are conducting an unprecedented monetary experiment. Called Quantitative Easing or “QE” they are printing truly vast quantities of money to buy assets (bonds in particular) manipulating their price to artificially reduce interest rates. They do this in the hope that low interest rates will encourage businesses to expand and invest. This business growth will in turn lead to a greater employment, and greater employment will lead to greater spending which in turn will lead to more growth and so on and so forth in a virtuous cycle. That’s the theory, anyway.

According to Grant’s Interest Rate Observer, this monetary revolution in the form of QE has been motivated by results drawn from the central bank’s favoured plaything, the impressive sounding “dynamic stochastic general equilibrium model”.

“Dynamic” refers to time; the model supposedly peers out over it. “Stochastic” refers to randomness; the model ostensibly incorporates it. “General” refers to the portion of the economy the model addresses; all of it, they say. And “equilibrium” refers to supply and demand; allegedly the two things are neatly in balance.

While the mathematics behind this monetary revolution may be elegant and rigorous, that’s no guarantee it’s a reflection of reality. We think many of the assumptions and goals behind QE fly in the face of simple common sense. Dirty Harry might say, “A model’s got to know its limitations.”

The solution to too much debt is not more debt

  • Rather than face up to the consequences of over-borrowing (both governments and individuals), we continue to borrow more and more to defer the necessary adjustments. This is only making the situation worse.

While you can create the money, you can’t control where it goes

  • Asset prices are on the up and up, but how much of the trillions being printed is reaching the real economy?

There’s no such thing as a free lunch

  • You can’t create growth out of thin air – only borrow it from the future. Credit-fuelled growth now will be offset by lower growth in the future when the debt must be repaid

You can’t measure yourself and bend the ruler at the same time

  • Does anyone notice the irony that they are benchmarking their success against the very measure they are manipulating?

Your model must take into account the nature of the underlying system

  • Markets behave normally, most of the time. But markets also exhibit a kind of wild randomness that might be predicted by chaos theory — they are dynamic, they can respond in a non-linear way. A tiny difference to seemingly stable conditions can result in monumentally different outcomes. Thus markets sometimes respond like systems ordered along the lines of self-organizing criticality – unstable, fragile and largely unpredictable.

Friedrich Hayek incisively said, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” I fear this experiment being undertaken by the world’s central banks will prove to be a disastrous way to re-learn this lesson.