Financial and Economic Modelling - A Waste of Time?

By Ron Robins, Founder & Analyst, Investing for the Soul

Blog Enlightened Economics; twitter

First published April 21, 2011, in his weekly economics and finance column at
alrroya.com

“…both risk models and econometric models… are still too simple to capture the full
array of governing variables that drive global economic reality," wrote Alan
Greenspan, former chairman of the US Federal Reserve in the Financial Times on
March 16, 2008. And if anyone should know about the quality and predictive validity
of such models, it would be Mr. Greenspan. Time and again it has been shown that
reliance on the predictions from such models is foolhardy.

It was the reliance on, and failure of their predictions, that caused enormous global
financial and economic carnage in 2008 and 2009. Yet today dependence on these
models seems greater than ever. I suggest our overt focus and use of them is often
a wasted effort.

A truth that many modellers and their followers seem to have difficulty accepting is
that the past—which most modellers use to prognosticate the future—has frequently
been shown to be a poor basis upon which to determine future outcomes. Modellers
can continue to refine their models in great detail, and then some unusual event
occurs with a one in a million chance of happening—such as the US sub-prime
mortgage fiasco—and their models fail. Sadly, the variables which may encompass a
one in a million event are numerous. Among them are sudden changes of investor
attitudes, weather patterns, geological events, and political and social upheavals.

If we look around today from the sudden movements in sovereign bond markets to
the extraordinary weather recently in Australia, to the horrific Japanese earthquake,
tsunami and nuclear reactor troubles, to the political upheavals in North Africa and
the Middle East—all are kinds of exogenous events that can trash the predictions of
the most exacting risk or econometric model.

Furthermore, a ‘perfect’ econometric model would only be possible, metaphorically

speaking, if the modeller had ‘the mind of the creator.’ Only then perhaps, could all
be known and predicted. Sadly—and I do not mean any disrespect to the modellers—
I do not believe that many (if any) of them have that level of intelligence and
consciousness at this time. So those constituencies that trust in these models are
doomed to suffer continuing disappointments.

Another problem with these models is how to model for human behaviour, as it is
both rational and irrational at different and unpredictable times. Therefore, before
such modelling can ever hope to fully succeed, it must completely understand human
consciousness: who we are, and how and why we act. And the modellers are a long,
long way from such an understanding. Incidentally, there is a branch of economics,
‘behavioural economics,’ that is moving in that direction. I wish them good luck with
that!

Economists today, unlike those of earlier eras, seem to believe that the only way
they can be perceived as legitimate is to be scientifically oriented. Hence their
passion for increasingly complex models and their statistician-like orientation.

The type of economic modelling that incorporates mathematics and statistical

relationships to economic data, is termed econometrics. Google econometrics and
you will probably find over 5,000,000 links. They are largely links to innumerable
academics, research institutions, studies, papers and journals. With so much effort
put into this field, any independent observer could conclude that econometrics must
be a highly successful and seemingly scientific endeavour. It reminds me of the
enormous quest for artificial intelligence (AI) to recreate the abilities of the human
mind in computers. At least AI is somewhat plausible as it advances the field of
computing and robotics which have many, many practical applications that we all
know about.

But unlike AI research, economic and econometric models—with their significant

variances and failures—have much less to offer society at this time. Mark Thoma,
Professor of Economics at the University of Oregon offers these pertinent remarks in
his blog, Economist's View, on February 8. “Much of the uncertainty in economics
derives from our inability to do laboratory experiments, and that includes uncertainty
about which model best describes the macroeconomy. When the present crisis is
finally over, those who advocated fiscal policy, those who advocated monetary
policy, and those who advocated no policy at all will all say ‘I told you so’ based upon
their reading of the evidence… the answers you get are only as good as the model
used to get them, and considerable uncertainty remains over which macroeconomic
model is best.”

In the 19th century's Europe and North America, there were no econometric models
(not in the way we know of them today), yet those continents experienced
unprecedented economic growth. And the concept of gross domestic product (GDP)—
which is usually a top concern in econometric modelling—was not created and used
until World War II.

We know that econometric models are unreliable in providing information on how

economies behave as well as their projections of future economic activity. Similarly,
modelling for financial risk has been shown to be more than problematic and history
shows reliance on risk models brings eventual failure and grief.

Therefore, given the facts, we need to be much, much less anxious about trying to
create perfect risk and econometric models—and not rely on these models,
generally. After all, it was mostly intuition and drive, not decisions based on risk and
econometric models that led our greatest inventors, financiers, entrepreneurs and
leaders to great success, thereby creating our modern economies.

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