Sunday, August 21, 2016

Ari Andricopoulos — On Maths and Models

Every now and then a debate seems to flare up about economic models. A recent one started with Noah Smith arguing (in reply to Frances Coppola), that heterodox economics does not have the tools to replace mainstream economics. Steve Keen gave an excellent point by point reply about the mathematical quality of heterodox work. Then Frances also wrote a reply and then another, which  I agree with, pointing out that an understanding of the economy does not require maths. Where maths can be used to formalise this understanding, it is very useful. But economics is not a mathematical equation.
I say this from the point of view of someone with a PhD in mathematics, but whose job is to predict the behaviour of systems, specifically financial systems. And I know that in describing a system, parsimony is king. One should use as much maths as is necessary and not a bit more. The more complex the maths, generally the worse the predictive power.
The economy is a very complex system. It is non-linear with a huge number of unknowns. For this reason prediction is difficult. This seems to have meant that any degree of poor prediction is excused on the grounds that no-one can predict the future. I recommend everyone read this excellent Noah Smith blog post from 2013 which was only let down by the somewhat cowardly conclusion.  It shows DSGE models are not useful as predictions - he points to this paper showing that DSGE models are no better than simple univariate autoregression (AR) models at predicting inflation and GDP growth. Bearing in mind AR models are just simple mean reversion models this is a pretty categorical failure. He then argues that they are neither good for policy advice nor even for communication of ideas, before concluding that we should continue with them as the are the 'only game in town'.
Saying that the economy can't be predicted because it is too complex and no-one knows the future is a big cop out for me. No-one could have predicted with any degree of certainty that the global financial crisis would happen in 2008. This is because it is impossible to predict the timing of events of this nature that depend on triggers and positive feedback loops. It also depends on policy reaction. For example, a possible crash in China early this year was averted by a large government spending programme. But what heteredox economics has done is give keys to understanding the nature of the economy.…
Notes on the Next Bust
On Maths and Models
Ari Andricopoulos | Partner at Dacharan Advisory, Zurich, and PhD in Mathematics

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