Even the most useful, most sophisticated models are only skeletal images of some full experience. Watching a simulation of a hurricane on a computer screen is a far cry from actually being in the midst of one. The chaos that ensues once a real battle is underway is never captured in a model of the conflict. The same is true of the real world of economics, which belies the models time and again. [FULL ARTICLE]
Source link: http://archive.mises.org/2023/the-myth-of-the-model/
The Myth of the Model
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The success of a model, along with the certainty of result it offers, can tempt its users to conflate it with reality. But the world is never ensnared in even the best of our nets.
If only more Austrians thought this way. An example of the typical Austrian view is provided by Robert P. Murphy, who writes:
But it is not necessarily mistaken to to perform experiments to see how well a model fits the real world. And a model is still subject to real-world verification, no matter how many “self-evident axioms” it is composed of.
A WSJ story earlier this week highlighted how Fed rate hikes might disrupt financial markets due to the way hedge funds currently operate. One investment manager commented that “There is no diversity in hedge-fund strategies. There is a huge concentration of positions and everyone is trading with Alan Greenspan’s money.” This creates the possibility that many highly leveraged speculators will encounter trouble simultaneously due to unforeseen interest rate-driven market changes, culminating in an LTCM-type crisis.
The problem arises from the fact that most hedge funds, banks, securities firms and even central banks are all using the same risk models. Nassim Taleb, an adjunct mathematics professor at the Courant Institute of NYU points out that just before severe declines, most models falsely predict low volatility. The Value-at-Risk models are flawed because they are backward looking, and cannot predict the timing or magnitude of severe declines. Since everyone uses the same flawed models, the probability that most hedge funds move at the same time and in the same direction increases. This can magnify market swings and reduce liquidity, straining financial markets and making adjustments more difficult.
Relatively new types of investments are uniquely susceptible to problems because there is less volatility history to model. One example is collateralized bond obligations, which are made up of tranches of corporate bonds. High-yielding, lower-rated tranches are riskier and can suffer steep losses if just one company in the tranche defaults on its obligations. In recent years, the high yield tranches of CDOs have performed much differently than the vaunted models predicted.
See Henny Sender, “Interest Rate Jolt Might Cause Sparks at Hedge Funds,” WSJ, May 17, 2004, C1.
What an intriguing article. I am not sure I understood it. I have never understood the concept of “random.”
A person working for an insurance company once explained: If you are insured for free against any car accident, and for a large amount of money so that you would gain substantial money from any accident, you will drive more carelessly than you otherwise would have.” He went on to explain that, while there may actually be exceptions to this rule (Who knows?), VIRTUALLY EVERYBODY claims to be the exception. He said that therefore, aside from insurance employees, almost no one used to believe him when he told them the rule.
Finally he found an argument that would convince people. He asked them that if there were a razor-sharp daggar firmly attached to the steering column of the steering wheel of their car, and pointed at their chest, and if they were forced to drive the car, would they not then drive the car somewhat MORE CAREFULLY than usual?
It was only in this way that people could be made to see that they DO adjust the safety of their driving habits according to the modification of the consequences of any slip-up.
Another example: In a heated debate, I recently heard somebody assert: “Bush COULD INSTANTLY stop the war against Iraq if he chose to!” I guess I agree. I guess that Bush could stop the war–in the same sense that I COULD, if I chose, get out my pistol and stop some passer-by and tell him to either give me all of his money or else die. Technically I have the resources and skill to do this. (For example, I can get hold of a weapon, and I can talk). And yet, we are speaking about human beings, and amongst human beings nothing is done without any motivation (excepting accidents). Motivation is absolutely crucial to telling what COULD happen. So maybe it is equally correct to say that Bush COULD NOT stop the war, and I COULD NOT conduct an armed robbery. mary
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