Categories

Pragmatic Capitalism

Practical Views on Money, Finance & Life

Models are Great if you Understand Their Limitations

Krugtron has a good post up today defending his use of the IS/LM model against some criticism.   I’ve had this back and forth with Dr. Krugman in the past so I won’t repeat many of my past points.  But I like the way he is framing this in this post:

“I read Syll’s paean to Minsky, and I have no idea how he would answer any of these questions. What I suspect, however, is that he would talk about complexity and nuance, and then propose answers without basing them on any model at all – which would in fact mean engaging in implicit theorizing, and probably fairly crude implicit theorizing at that. You see that a lot among people who reject IS-LM as too simple and unsubtle: what they have ended up doing in practice, for the most part, is predicting soaring inflation and interest rates, because whether they know it or not they have effectively reverted to crude quantity-theory and loanable-funds models.”

This was the essence of my previous discussion with him.   The IS/LM model can be highly misleading if you view it through a quantity theory and loanable funds model.  I won’t be presumptuous and claim that this is a change in direction for Dr. Krugman though it sure looks like a big change from his 1998 paper where he said “Banks, however, need hold only a fraction ar of their deposits in reserves and will hold no more than necessary; they lend the rest out (which is how consumers get the money for the deposits)”.  Clearly, those two views are not compatible.  But whatever.  He knows IS/LM can’t be used as a loanable funds model.  That’s great!

And that’s the key.  I think that economic modelling is very useful.  It helps conceptualize important points and gives us a general framework for understanding the world.  But we should also be aware of the weaknesses embedded in many of these models because many of these models are simplified to the point that they are misleading.  And this stems from another big problem revolving around the way many economists obsess over mathematics.   I finished Piketty’s Capital last night and loved this line:

“To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences. Economists are all too often preoccupied with petty mathematical problems of interest only to themselves. This obsession with mathematics is an easy way of acquiring the appearance of scientificity without having to answer the far more complex questions posed by the world we live in. “

Yes!  And what this childish passion for math does is lead to an unhealthy dependence on models.  Dr. Krugman mentioned a “turning point” in economics where we veered more towards this mathematical obsession.  And the problem was, in doing so, we veered further away from  reality.  In fact, the “language” of economics is not math.  It never has been.  The “language” of economics is accounting.  And accounting is about studying the world we live in and applying the proper relationships in a coherent manner.   And that’s the problem with a lot of the economic  modelling that’s being done today.  It is often based on such a crude version of reality that it becomes useless or extremely misleading.  When we think of the monetary system we have to start with a sound understanding of what is.  And that means that we need to understand the relationships between the different institutions in the monetary system and how they’re interrelated.  And that requires an understanding of financial accounting.  Once we get beyond that essential framework, we can apply math-based models more coherently.  But if you misunderstand the accounting the math is more likely to fail you.

So yes, models are great.  I love models.  But they are often misleading if we don’t understand their limitations.  And undertanding those limitations is grounded in something deeper than the math embedded in the model.

 

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering low fee asset management, private advisory, institutional consulting and educational services.Cullen is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
Cullen Roche

Latest posts by Cullen Roche (see all)

Did you have a comment or question about this post, finance, economics or your love life? Feel free to use the discussion forum here to continue the discussion.*

*We take no responsibility for bad relationship advice.