Economic Modeling

When I first started learning about Development Economics (in Public Policy 184, Poverty and Policies in Developing Economies, which I actually eventually dropped in favor of other things) I was struck by a lecture on the Harrod-Domar model because it was very obvious to me that the model was completely insufficient and overly simplistic. I had already read The Elusive Quest for Growth by William Easterly who basically made fun of people for ever believing this model could accurately describe anything (Easterly sums it up as “GDP growth will be proportional to the share of investment spending in GDP.”). 

After class I decided to ask the Professor about what the benefit of studying a model like this was since there were clearly hundreds of other factors which played a role. She explained that while this was absolutely true, it was important to try to strip away as many factors as possible and build something that one can easily reason about and see if it still makes useful predictions because it can help one get a better understanding of what is actually going on.
One should be careful to realize that there may be lots of other processes at work but that trying to understand all processes at once was not going to lead to any useful analysis. While the Harrod-Domar model is in fact far too simplistic – it’s assumption of constant returns to capital make lots of sense in the short term when there is high unemployment but makes little sense once there is a balance between labor and capital – it did lead to a better understanding of some of the processes at work.

While reading a piece by Paul Krugman on High Development Theory (more on that in a future post) I was struck by this following explanation of how useful simple models can be:

Dave Fultz was a meteorological theorist at the University of Chicago, who asked the following question: what factors are essential to generating the complexity of actual weather? Is it a process that depends on the full complexity of the world — the interaction of ocean currents and the atmosphere, the locations of mountain ranges, the alternation of the seasons, and so on — or does the basic pattern of weather, for all its complexity, have simple roots?

He was able to show the essential simplicity of the weather’s causes with a “model” that consisted of a dish-pan filled with water, placed on a slowly rotating turntable, with an electric heating element bent around the outside of the pan. Aluminum flakes were suspended in the water, so that a camera perched overhead and rotating with the pan could take pictures of the pattern of flow.

The setup was designed to reproduce two features of the global weather pattern: the temperature differential between the poles and the equator, and the Coriolis force that results from the Earth’s spin. Everything else — all the rich detail of the actual planet — was suppressed. And yet the dish-pan exhibited an unmistakable resemblance to actual weather patterns: a steady flow near the rim evidently corresponding to the trade winds, constantly shifting eddies reminiscent of temperate-zone storm systems, even a rapidly moving ribbon of water that looked like the recently discovered jet stream.

What did one learn from the dish-pan? It was not telling an entirely true story: the Earth is not flat, air is not water, the real world has oceans and mountain ranges and for that matter two hemispheres. The unrealism of Fultz’s model world was dictated by what he was able to or could be bothered to build — in effect, by the limitations of his modeling technique. Nonetheless, the model did convey a powerful insight into why the weather system behaves the way it does.

Much has been said of late about how Krugman specializes in building highly stylized and extremely simple (and initially much criticized) models that turn out to capture everything that is necessary to prove his point:

You make a set of clearly untrue simplifications to get the system down to something you can handle; those simplifications are dictated partly by guesses about what is important, partly by the modeling techniques available. And the end result, if the model is a good one, is an improved insight into why the vastly more complex real system behaves the way it does.

In many of my later Economics classes I found that most Professors just taught the models without explaining their inherent limitations and it made everything feel fake – instead of using the models to elucidate the underlying processes they were using smoke and mirrors to make simplistic points. Lectures became intricate exercises in trying to figure out where the models broke down and started diverging from reality when the lecture itself never mentioned the fact – a useful exercise for the conscious student but very dangerous for everyone else. In conclusion, models are extremely useful in studying economic proccesses (and many other things) as long as one is aware of the limitations, or in Krugman’s words:

The problem is that there is no alternative to models. We all think in simplified models, all the time. The sophisticated thing to do is not to pretend to stop, but to be self-conscious — to be aware that your models are maps rather than reality.

The Financial Crisis Abroad

When not writing about Sarah Palin or the Presidential Election, most American news sources are focusing on the Financial Crisis the world is going through right now. Most of my readings on the topic have come from Greg Mankiw’s blog via his excellent ‘Commentary on the Financial Mess’ posts which link to recent articles by important Economists from all over the web and has provided an incredibly rich collection of opinions and theories on what is going on in the economy.

Unfortunately, while some of these do touch upon the situation in other countries, most of them are very US centric. The Economist does a very good job of covering the situation in other countries, this week it had an interesting briefing on how the global financial crisis is impacting Eastern Europe. But the Economist has only so much space to devote to the issue each week and I have found that most of my information actually comes from the excellent Europe focused A Fistful of Euros blog. They seem to be having some issues with broken links right now (especially in their archive) but if you want detailed information about the impact of the crisis on Europe this is an excellent source. Many of their recent blog posts have been extremely detailed and informative so head over there and check it out. Here are their articles on Hungary, Kazakhstan, Spain, and the Baltic States

Simone White – The Beep Beep Song

These days I spend most of my time listening to The Economist Audio Edition or Podcasts and don’t have nearly enough time to listen to music (though I still make it to concerts – I saw Stereolab at the Fillmore yesterday). Furthermore, this blog is largely focused around academic subjects, but music is still a big part of my life and as such I wanted to post the video for incredible an incredible song by Simone White here:

I heard about it through a very clever and beautiful commercial for the relatively new Audi R8 supercar (which I first saw last summer in Monterey and have seen all over the place since then). Enjoy.

Cyclically Adjusted P/E: A Reason for Optimism with a Note of Caution

I first read about Cyclically adjusted Price to Earnings Ratio in Greg Mankiw’s post last week (referencing a WSJ article) and thought it was interesting but this week’s Economist article on the matter made me want to post it. Here’s the explanation from the Economist:

In his book, “Irrational Exuberance”, Robert Shiller calculated the cyclically adjusted price/earnings ratio over history. This measure, which takes an average of profits over the previous ten years and adjusts for inflation, is superior to the traditional p/e ratio because profits are highly volatile. In January 2000 the cyclically adjusted p/e on the S&P 500 was 44.3; the previous peak, just before the crash of 1929, was 32.6. That suggested markets had a long way to fall. And share prices did indeed suffer a long period of decline.

And here the gist of why this is a reason for long term optimism from Mankiw:

[T]he Standard & Poor’s 500-stock index is priced at 15 times earnings by the Graham-Shiller measure. That is a 25% decline since Sept. 30 alone. The Graham P/E has not been this low since January 1989; the long-term average in Prof. Shiller’s database, which goes back to 1881, is 16.3 times earnings. But when the stock market moves away from historical norms, it tends to overshoot. 

And a reason as to why investors should be careful about acting on this advice without careful consideration (from the Economist again):

Why does this matter? The existence of a bear market does not preclude the possibility of fantastic returns over shorter periods. Indeed, one striking point about the Dow’s 936-point gain on October 13th was that it climbed more in that one day than it did in the first 85 years of its existence (it was founded in 1896). Two of the very best years in American stockmarket history were 1933 and 1935, right in the middle of the Depression. But bear markets behave rather like Lucy in the Peanuts cartoon strip. Just when Charlie Brown is persuaded to attempt to kick the football, she snatches it away. Just when investors are persuaded the bottom of a bear market has been reached, share prices slump once more.

The Cost of Doing Nothing

After overhearing two friends talking about how the money budgeted for the bailout could be used for better things I wanted to post two excerpts from an Economist article on the British banking bailout. Leaving aside the exact details of the US plan the important point to underscore is that there are two sides to the issue of budgeting – government spending and government revenue. While the bailout is clearly a drain on the budget, so is a slowing economy, and a dramatically slowing economy would be an economic nightmare. So spending money to help avoid economic disaster is a good idea, and an approaching recession is the wrong time to bring on budgetary austerity. Next up – getting the details of the bailout as right as possible.

Government Spending:

Such a ballooning in the government’s liabilities may seem ominous, but this is to look at only one side of the public balance-sheet now that the Treasury has turned banker: on the other side stand the assets. [...] In 40 banking rescues studied by Luc Laeven, an economist at the IMF, the taxpayer typically recouped some but not all of their cost. 

Set against this, the stakes are intended to be temporary, and the public purse could profit when the shares are eventually sold. Taxpayers could also make running gains from the overall package, says Ben Broadbent, an economist at Goldman Sachs, a bank. Although the Treasury will have to pay interest on the new gilts it issues to fund the recapitalisation, it will recoup over half of this from the 12% interest its preference shares in the banks will earn. It will also charge fees for the guarantees it is providing on £250 billion of new debt issued by British banks—another part of the rescue package. Putting it all together, Mr Broadbent estimates that the net gain to the exchequer—assuming it does not have to pay out on the guarantees—could be nearly £3 billion a year.

Government Revenue:

Recessions wreak havoc on the public finances by both cutting tax revenues and raising unemployment-related spending. For every percentage point that GDP is lower than expected, public borrowing will be roughly £7.5 billion higher than forecast in the first year, rising to £10 billion higher in the second year, according to the Treasury’s ready reckoner. If the economy were simply to stall in 2008-09 and 2009-10, this could double planned borrowing of £38 billion next year; if output were to contract over the period the outcome would be costlier yet. 

Why I love the Economist

Well, there are many reasons, but one is wit:

In April 2007 Gazprom, an energy firm controlled by the Kremlin, made a Dr-Evil-style prediction that its market value would reach $1 trillion (ten times today’s level). 

- Emerging markets and the global financial turmoil, The Economist, Oct 11th 2008

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