Saturday, January 5, 2013

Why Economic Models Fail?

As the European Union grapples to find a solution to the ongoing debt crisis, several stories that point towards the flaws in the European economic model seem to be doing the rounds. What is it about economic models, that it never manages to give us an accurate representation of the real issues bogging down the economy? Are economic models too old school to be realistic? There are many who would agree to this, we must discover why.

Factors Behind the Failure of Economic Modeling

An economic model is a framework used to predict economic trends with a considerable degree of precision. They are used at the micro and macro level. The primary purpose of an ideal economic model should be to take the analyst as close to reality as possible. Unfortunately, even with the presence of several techniques, economic models can end up being disastrously misleading. Speaking of techniques, critics of economic models are coming down heavily on their blatant failure to predict any crisis. Here are some reasons.

Flawed Techniques
Human behavior is too erratic to be having a mathematical representation. Stochastic models allow a lot of randomness, whereas non-stochastic economic models pump in too much of logic, especially when it comes to predicting consumer choices, making the results go haywire. Ultimately, an algorithmic equation cannot replace the complex human thought process. Adding variables to it will only make it applicable in a 'perfect' world.

Unfeasible Qualitative Models
Bringing in equations to mimic human behavior is the basic flaw in economic models. But the absence of any mathematical representation, as in the case of qualitative models, increases the unreliability factor further. Qualitative models have the reputation of being imprecise.

Ignoring Simplification
Considering the complexity of arriving at a decision in business, an economic model is created with the aim of making things simpler. It plays the role of a guide, giving us a feel of the real world conditions. However, by bringing in too many variables, it ends up being the exact opposite. Models that are too complex make interpretation difficult, thus defeating the purpose of having one in the first place.

'Good' is Not 'Practical'
What defines a 'good' economic model? The one that is crammed with variables to paint an accurate picture of reality? Or is it the one that zeroes in on the nature of the problem, making appropriate recommendations to combat it? No prizes for guessing that it is the second one. Trouble starts brewing when economists get carried away trying to make it a mathematical procedure by compromising on reality. There exists a thin line between 'good' and 'useful', really.

Wrong Assumptions
Models created to make market forecasts can be severely misleading, especially when certain factors are overlooked or taken for granted. Economists are often known to make the mistake of assuming that consumers are always rational. This makes for an excellent intellectual base, but they completely ignore the emotional aspect of making a decision, which obviously affects the forecasting of economic trends.

Hypothetical Means Hypothetical
Economic models are based on hypothetical situations. A hypothetical situation is what it is; simply put, it is not reality. It is hard to find an economic model that mirrors the situations present in the actual market. When you keep tweaking the parameters to suit your hypothesis, it is time to scrap it entirely.

No Place for Intuition
Economic models have no regard whatsoever for human intuition. The cold, hard logic that is employed, has disaster written all over it. Do you think economists did not foresee this crisis? You bet they did, by which time it had totally spiraled out of control. This brings us to question the reliability of these models. If human behavior could be demonstrated with the help of equations, it would have given credibility to economic models.

Weak Financial Risk Modeling
Financial risk modeling makes use of several techniques to predict possible losses in the investments made. It is a tool used to measure viability of purchase and sales decisions, and aids in maintaining capital reserves. Unfortunately, since the past few years, risk modeling has come under the scanner for its inability to prognosticate the Financial Crash of 2008, and earlier, the Enron scam.

Economists worldwide have tried to find a way to interpret human behavior and incorporate all the anomalies that come with it, into an ideal economic model. As of now, no one has succeeded in capturing human tendencies into equations, and it is unlikely to happen in the near future. The aftermath of this financial crisis has seen many voices rise against the existence of financial models, and rightly so. However, if we can accept that economic models can never replace common sense, we can arrive at a consensus. How? By simply using the predictions as references and not as judgments. Finally, a model is a model, it ain't human.
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