Saturday, January 7, 2012

"Derman, Rodrik and the nature of statistical models"

From Numbers Rule Your World:
I just finished Emanuel Derman's new book, "Models Behaving Badly", which is a good introduction to the philosophy of statistical models. The topic has been swirling in my head after also having read this article by economist Dani Rodrik, who reflected on the recent walkout by some Harvard students of their introductory economics course.

In Rodrik's view, the students were right to protest the economics profession because the economic models being taught in the classroom are too simplistic. He paints a particularly eye-opening - and damning - scenario: in the undergrad classroom, as well as in public, the economist admits no doubts about his ideologies (such as "free trade", "free market") but in his "advanced graduate seminar on ... theory", the same professor would debate with skeptics, leading to a "heavily hedged statement" after "a long and tortured exegesis". The statement would begin with "if the long list of conditions I have just described are satisfied, .."

I could imagine Derman entering that graduate seminar, and declare everything as nonsense. (Derman currently teaches in the Financial Engineering program at Columbia, and previously worked on Wall Street as a "quant" building economic models, after spending his graduate career working with models of the physical world.) "Models Behaving Badly" is about how economic models can go off-track, how frequently they do, and why modelers must behave modestly. Derman would argue that Rodrik's "long list of conditions" are almost never satisfied.
There is a crucial difference between the assumptions made by the Black-Scholes Model and the assumptions made by a souffle recipe. Our knowledge about the behavior of the stock markets is much sparser than our knowledge about how egg whites turn fluffy.
He goes on to argue, perhaps unexpectedly, that the Black-Scholes Model is "the best model in all of economics". He aims his criticism squarely at the sacred cow of financial economics, the "Efficient Market Hypothesis".

Rodrik does not believe that the economics profession needs better models. He claims "Macroeconomics and finance did not lack the tools needed to understand how the crisis arose and unfolded." The fault of the profession was to have trusted the wrong models (ones assuming efficient and self-correcting markets). He believes that this bad choice of models is facilitated by "excessive confidence in particular remedies - often those that best accord with their own personal ideologies."

It isn't clear to me how Rodrik proposes to resolve the ideology problem. In fact, his citation of another economist Carlos Diaz-Alejandro perfectly captures the heart of the issue: "by now [1970s] any bright graduate student, by choosing his assumptions... carefully, can produce a consistent model yielding just about any policy recommendation he favored at the start."...MORE