Noah Smith has an interesting post up today discussing a new study that questions the validity of basing economic models on the assumption that people’s preferences are stable. Now, if you’re a layperson or a market practitioner you probably think that’s a silly assumption to begin with. Markets are, as Warren Buffett referred to them, “manic”. An economic system is a non-linear dynamical system. So when we start trying to model that system like it exists in a vacuum then you inevitably come to this conclusion (per Noah):
“Modern (“neoclassical”) economic theory has been pretty successful at describing people’s decision-making patterns in static settings, but not so good at describing how people make decisions in dynamic settings.”
In other words, you get conclusions that don’t reflect our reality very well. That’s not really all that surprising. The microfoundations of modern economics are based on all sorts of similarly flawed assumptions that leave cracks in the models. That’s why we have things like the Efficient Market Hypothesis and Rational Expectations to begin with. Economists prefer not to look at the world for what it is, but instead prefer to construct models by extrapolating faulty micro assumptions out into the entire macro system.
Anyhow, it would be my hope that this starts to reframe the discussion a little bit. Economics is too important to be left entirely to biased theorists who refuse to try to better understand reality. But I doubt anyone will seriously consider changing their models much because that would also involve a lot of mea culpas. And since we’re totally irrational animals, we’d prefer not to deal with mea culpas because then everyone might perceive us as being weak even though the mea culpa will actually improve our thought processes. Oh well.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He 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.