Why Do Our Economic Models Keep Failing?

Via Ryan Avent, I came across this fascinating interview about why economic models always fail us in crisis. That's a big question, so fortunately the professor has a really great historical analogy to start us off. A group of Swiss soldiers get lost in the Alps and the weather take a bad turn. One soldier realizes he has a map and they follow it until they find a town to take shelter. But when they explain what happened to their commander he realizes that's it's not a map of the Alps: it's of the Pyrenees.

The conversation turns to the current financial crisis and whether we've been using the wrong economic "maps" to guide our economic policies. Here's Prof. Daniel Kahneman

"Greenspan and others believed that the global system - by virtue of its being global - was ipso facto more stable. Then it turned out that while it might have been more stable, it was also more extreme.

"In the last half year, the models simply didn't work. So the question arises: Why do people use models?"

Well, that question isn't too hard to answer. We build models so that we can feel confident about the direction of our policies and so that we can anticipate shocks to the system. Right now, obviously, we're suffering from an incredible shock due, perhaps, to the incredible (over-)confidence that inflated Wall Street.It seems to me that what happened wasn't that our economic models were doomed to failure, but the ivory tower economic theory failed to keep up with the Wall Street math.

That's where I'd bring in two essential bits of reporting from the financial crisis: Recipe for Disaster, Felix Salmon's awesome look at the "formula that killed Wall Street" by giving investors the pyrite confidence that they could assess and manage risk in the mortgage industry; and My Manhattan Project, a New York confessional from the guy who wrote the software turning mortgages into bonds. The latter guy fundamentally changed the game by drawing a straight line from mortgages to bank performance (and, by extension, to insurance companies, credit default, pensions, everything, etc) and the first guy insulated the crazy new system from scrutiny by writing a code that pretended to predict risk that it could not. If economic models rely on math and a modicum of rational actors, these guys took the rug out by changing the math and adding the illusion of rationality. The models rotted from within.

"Look, it's possible that there simply is no map of the Alps," the professor muses. Maybe not. But it's also possible that we had a perfectly fine map of the Alps at some point and that the earthquake described simply changed the landscape, irrevocably.