Speaking of Models

March 1, 2009

by Gene Callahan

In a physical science, such as, say, astronomy, if the physical world disagrees with our model, we correct the model. For instance, imagine that our model predicts that Venus will be at a certain place in the sky tomorrow night. Tomorrow night we turn our telescope to that place in the sky and find that Venus is nowhere near there. What we do is we go back to the drawing board and devise a new model.

Now let us look at this economics paper that our friend Bob Murphy over at Free Advice alerted us to. Two economists examine the issue of whether Irving Fisher was correct to claim, before the crash of 1929, that stocks were undervalued at the time. If undervalued is going to have any objective meaning at all, it is going to have to mean something like “Gee, I really regret not having invested in stocks at that point because they did very well from then on out.” On the other hand, stocks being overvalued, to be an objective statement, must mean something like “My God, investing in stocks at that point sure would have been stupid.”

But look at what these two economists conclude — “The evidence strongly suggests that Fisher was right. Even at the 1929 peak, stocks were undervalued relative to the prediction of theory.” So, in other words, faced with a disagreement between their model and reality, these chaps conclude “our model is right; reality will have to be corrected.” And look at what they term “the evidence” — not reality, but “the prediction of theory”! Their model is evidence that reality was off the mark.

Methinks there is something seriously amiss here.

7 Responses to “Speaking of Models”

  1. pochp Says:

    There’s something seriously amiss all right: they were both hallucinating.

  2. Mario Rizzo Says:

    While I have not read the paper, this is what economists (and others) sometimes call a normative model. It is widely used in behavioral economics: If people did not make mistakes or did not have systematic biases, then they would do X. Instead, they mistakenly do Y. So X is the normative prediction and Y is what we observe. In my view, it is usually dangerous to prescribe behavior in complex situations.

  3. pochp Says:

    Nice research Mario.

  4. Bob Murphy Says:

    And just to clarify my own position on this stuff: It would have been perfectly fine (in my opinion) if the 2003 paper said, “Fisher was understandably wrong. Using modern financial models, we also find the stock market in 1929 was undervalued, and so people should stop ridiculing Fisher with his horrendous predictions. The puzzle is to figure out why the models were so wrong in this instance…”

    But as Gene points out, that’s not what they said in the paper.

    Paul Samuelson is the king of this conflation (is that a word?) of model and fact. When refereeing a dispute in the history of economic thought, Samuelson will see which economist’s verbal exposition in the 19th century comes closest to Samuelson’s modern-day formal model, and then that guy wins the debate.

    Now if something like this happens in physics–where for example we credit Newton’s theory of light for being remarkably “modern” a la quantum physics–that is defensible because quantum physics has yielded remarkably precise experimental predictions. I don’t think Samuelson can say the same thing about his models, or the model of the two authors defending Fisher.

  5. ed story Says:

    I think you all are being academic with the academics on a non-scientific exploration. Economics is supposedly the social science of supply and demand or the production, distribution, and consumption of goods and services and all related fields that contribute to that paradigm. Now then it is my understanding to claim science as a descriptor they – ‘the economists’ used physics formulas in place of non scientific calculations and called it science. Problem is one did not study the theory and then assign calculations to the observed events because they are completely random until manipulated by those capable of manipulation of the system. Gold price is a good current example of the manipulation and the unmistakable falseness of the calcuations.

  6. Danny Shahar Says:

    *covers head with The Economic Point of View and waits for explosions*

  7. gcallah Says:

    Ja der Satz ist kryptisch tatsächlich.


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