Posts filed under “Mathematics”
On Tuesday, the 2nd most emailed article on WSJ.com was Crisis Compels Economists To Reach for New Paradigm.
It is an intriguing look at the problems of the the field of economics. It went, however, way too easy on both the profession and its practitioners. The article fails to ask some very basic questions about the soft science, and does not discuss the fundamental incompetency of many economists.
Given the failures of the profession — failing to anticipate the worst recession in decades, missing the warping effect of the housing boom, not recognizing the credit collapse until too late — a damning indictment of the dismal science might have been more appropriate.
Perhaps I can be of assistance.
There are many areas I would have liked to see the Economics Crisis article explore: The lack of Scientific Method, the mostly awful performance of economists, its misunderstanding of the value of modeling, the bias inherent in Wall Street variant of economics, and lastly, the corruption of economics by politics. I will just touch on some of these; you can fill in much of the blanks yourself.
Let’s start with the basics. Hard “science” — Physics, Biology, Chemistry, and all variants thereto — begins humbly. They try to describe the universe around us by creating theories, and then testing them. These theorems are always preliminary. Even when testing validates them, Science is always prepared — even eager — to replace them with newer theories that are proven to be even more valid.
The humility of science begins with an admission: We know nothing. We seek to learn through experiment and logic, and constantly evolve more and more accurate explanations. Scientific belief evolves gradually over time. Nothing is assumed, presumed, or hypothesized as true. Indeed, research is a presumption that current theories are inadequate or incomplete. The practice of science is a an ongoing search for better explanations, more proof, further verification — for Truth.
Science is the ultimate “show me” state.
Economics has a somewhat, shall we call it, less rigorous approach. Indeed, the arrogance of economics is that it is the polar opposite of Science. It begins with a few basic assumptions, many of which are obviously untrue; some are demonstrably false.
No, Mankind is not a rational, profit maximizing actor. No, markets are not perfectly, or even nearly, efficient. No, prices do not reflect the sum total of all that is known about a given market, sector or stock. Those of you who pretend otherwise are fools who deserve to have your 401ks cut in half. That is called just desserts. The problem is that your foolishness helped cut nearly everyone else’s 401ks in half. That is called criminal incompetence.
Where was I? Ahhh, our sad tale of the practitioners of the dismal arts.
Starting from a false premise that fails to understand the most basic behaviors of the Human animal, economics proceeds to build an edifice of cards on a foundation of sand. (How could that possibly go astray?) Like a moonshot off by a few inches at launch, by the time the we reach further into time and space, the trajectory is off by millions of miles . . .
Economics has had a justifiable inferiority complex versus real sciences the past century. It has attempted to overcome this by throwing lots of smart mathematicians at its practice, in an attempt to make the social art seem more “sciency,” and thus more credible. This had led to lots and lots of formulas and models. The problems is, Economics places way too much weight on these. It creates an illusion of precision where none exists. The belief in their models led to all manner of mischief, from subprime to derivatives to risk management.
Economics forgot George E. P. Box’s most basic rule:
“Essentially, all models are wrong, but some are useful”
Box was a statistician who recognized the fundamental truth of all attempts to depict the universe mathematically: They are inherently flawed.
He also understood that these flawed attempts can at times have value. His insights contextualize what mathematical modelers do — and fail to achieve.
Economics fails at this often. The belief in the validity of their models — like the theories they are based upon — is the Achilles heel of the profession.
This is not to say there are not good, even great economists (some are even friends of mine!) who foresaw the coming crisis and warned about it. Many are aghast at the rigor mortis in the academic establishment; some are horrified at how poorly the profession has done. Forget forecasting the future, too many economists cannot accurately describe what happened yesterday.
The Behaviorists have been fighting the mainstream for decades now, trying to correct the errors of the basic building blocks of the dismal science.
Excerpt after the jump.
The Mystery of the Awful Economists
RealMoney.com, 3/2/2005 3:42 PM EST
(If you cannot access the Real Money piece, click here).
Mystery of the Awful Economists, part II (April 8th, 2005)
Mystery of the Awful Economists part III (April 13th, 2005)
RIP Chicago School of Economics: 1976-2008 (December 23rd, 2008)
Why Economists Missed the Crises (January 5th, 2009)
Crisis Compels Economists To Reach for New Paradigm
WSJ, NOVEMBER 3, 2009
An odd article in the today’s WSJ laments The Cruel Math of Big Losses. What a terrible misonomer: This article should have been called “The Basic Mathematics of the Stock Market.” Not understanding the simple percentages of losses and gains is a goodly part of the reason so many investors buy into the myth of…Read More
I stand before you chastened, a humble man who is must admit the errors of my ways. You see, I thought the bailouts were going to be terribly expensive. Adding up all of the direct cash injections, loans, assumptions of debt, commitments, guarantees, and other obligations, I reached the unimaginable sum total of $14 trillion…Read More
> Right now, its the 9th second of the 9th minute of the 9th hour of the 9th day of the 9th month of the 9th year of the century. You may now return to your prior activities . . . >
“The government has taken profits of about $1.4 billion on its investment in Goldman Sachs, $1.3 billion on Morgan Stanley and $414 million on American Express. The five other banks that repaid the government — Northern Trust, Bank of New York Mellon, State Street, U.S. Bancorp and BB&T — each brought in $100 million to…Read More
Via Bob Bronson, we get this very interesting way to think about the potential universe of market returns: In addition to the almost universally improper use of the correlation function that we have presented before (our Correlation Puzzle is available on request), Alpha-Beta, Efficient Frontier, Black Scholes, VaR, stochastic modeling, and exotic derivatives from Modern…Read More
Stephanie Pomboy of MacroMavens observes: “Judging by the giddy delight investors have taken in ‘better’ earnings news over the last two weeks, we expect they will positively wet themselves when they get a load of the new saving stats. I mean the prospect that dis-saving was never as bad… and that current saving is even…Read More
Bill King notes in the Think Tank that GDP was actually worse than consensus expected. How is a minus 1% worse than a minus 1.5% ? He looks at the first half of 2009, and blames the Q1 revisions: “We will again utilize basic math to illustrate the scam. If Q4 08 GDP was 100…Read More
> The GDP report last Friday evinces the folly of US government economic statistics and Wall Street consensus analysis. Most of the Street heralded the 1% decline in Q2 GDP because it was 0.5 better than consensus – even though the US government admitted in the release that its GDP estimates over the past several…Read More
I notice that Jim Cramer is yowling on TheStreet.com today, pounding the table on US Bancorp (NYSE:USB) and Webster Savings Bank (NYSE:WBS). Jim, how much you want to buy? These institutions are going to be shoveling money into the furnace for another 3-4 quarters. We’ll have a post up on TBP tomorrow on our view…Read More