But prediction need not always be the criterion for success of an economic model. Clearly, if we are judging a forecasting model, we want it to predict well, in some well-defined sense. But in other cases forecasting is not the name of the game. In arbitrage pricing, under some assumptions the model implies that changes in asset prices cannot be successfully forecast. By the criterion of prediction, the model is indeed a total failure. It tells you that a monkey could do as well at predicting asset prices as an economist who understands the model. Yet the model is actually not a failure, as it teaches us something interesting.
With financial crises, a similar issue arises. By its nature, a financial crisis is an unpredictable event. We could have an excellent model of a financial crisis. The people living in the model world where the financial crisis can happen know it can happen, but they can't predict it, otherwise they could profit in advance from that prediction. Similarly, an economist armed with the model will not be able to predict a crisis in the real world. A nice example is in Ennis and Keister (2010), which is a variant of a Diamond-Dybvig (1983) banking model. In Ennis and Keister’s world, a rational and benevolent policymaker and a set of rational consumers live in an environment where a banking panic can happen. When the policymaker sees the beginnings of a panic, he or she starts to intervene, but rationally discounts the severity of the panic until the panic is too full-blown to actually prevent. Thus, the panic can happen even if the policymaker has the right model, and the policymaker with the right model indeed cannot predict the panic.
Monday, February 6, 2012
Why Economists Are Right
Here's an excellent piece by David Levine in the Huffington Post. There are some related ideas in this article of mine. Excerpting from the latter: