Economists often get criticized for basing their models on completely unrealistic assumptions. For example, that people are fully rational and operate with near perfect foresight. That markets always find an equilibrium. That all people in an economy, rich or poor, well connected or not, can borrow funds at precisely the same rate of interest. Etc. I’ve criticized all this stuff myself before; this is an old story.
Even worse than the unrealistic assumptions, however, are the slippery and, I think, rather dishonest ways economists often defend such assumptions. They’ll refer to Milton Friedman, who famously claimed that the plausibility of a model’s assumptions doesn’t matter, only whether it makes good predictions or not. Or, they’ll say “we don’t really believe the model, but it helps us tell a story and understand what is happening in the economy.” I’ve written about this “story telling business,” as well as the basic illogic of Milton Friedman’s argument.
But this new article by Stanford economist Paul Pfleiderer is an absolute must read for anyone interested in what economists get up to, or who wants to understand how it is that economists think it is OK to go on using completely implausible models to support real world policy propositions. His argument is that many models used in economics are like chameleons, changing their color to suit the moment. It goes as follows:
Theorists make crazy assumptions C, and use them to derive a result, X, which seems to support some policy, like, derivatives are always good, improving economic efficiency, etc. “Our model shows X,” they claim. It becomes known in the profession that there is an economic model which shows X, and many people forget about, or ignore, the crazy assumptions C needed to derive X. People widely believe that derivatives are always good; after all, it’s been demonstrated in a model. If someone else points to the crazy assumptions C, then the chameleon changes: “We’ll, you can’t criticize the model’s assumptions, after all a model is merely a logical exercise showing a connection between assumptions and conclusions.” The chameleon either 1) hides the assumptions and sticks its neck out, making bold claims about the real world, or 2) acknowledges its assumptions and says, hey, I’m only a model! The model, in Pfleiderer’s colorful language, wants to claim “diplomatic immunity.” It wants to be policy relevant even though it is based on crazy implausible assumptions. This where alcohol comes in.
I must quote a terrific short section from Pfleiderer’s paper, where he gives an example of a chameleon model in action, and illustrates it’s weird logic with full clarity using an alcohol analogy:
In April 2012 Harry DeAngelo and René Stulz circulated a paper entitled “Why High Leverage is Optimal for Banks.” The title of the paper is important here: it strongly suggests that the authors are claiming something about actual banks in the real world. In the introduction to this paper the authors explain what their model is designed to do:
To establish that high bank leverage is the natural (distortion-free) result of intermediation focused on liquid-claim production, the model rules out agency problems, deposit insurance, taxes, and all other distortionary factors. By positing these idealized conditions, the model obviously ignores some important determinants of bank capital structure in the real world. However, in contrast to the MM framework – and generalizations that include only leverage-related distortions – it allows a meaningful role for banks as producers of liquidity and shows clearly that, if one extends the MM model to take that role into account, it is optimal for banks to have high leverage. [emphasis added]
Their model, in other words, is designed to show that if we rule out many important things and just focus on one factor alone, we obtain the particular result that banks should be highly leveraged. This argument is for all intents and purpose analogous to the argument made in another paper entitled “Why High Alcohol Consumption is Optimal for Humans” by Bacardi and Mondavi.5 In the introduction to their paper Bacardi and Mondavi explain what their model does:
To establish that high intake of alcohol is the natural (distortion free) result of human liquid-drink consumption, the model rules out liver disease, DUIs, health benefits, spousal abuse, job loss and all other distortionary factors. By positing these idealized conditions, the model obviously ignores some important determinants of human alcohol consumption in the real world. However, in contrast to the alcohol neutral framework – and generalizations that include only overconsumption-related distortions – it allows a meaningful role for humans as producers of that pleasant “buzz” one gets by consuming alcohol, and shows clearly that if one extends the alcohol neutral model to take that role into account, it is optimal for humans to be drinking all of their waking hours. [emphasis added]
The Deangelo and Stulz model is clearly a bookshelf theoretical model that would not pass through any reasonable filter if we want to take its results and apply them directly to the real world. In addition to ignoring much of what is important (agency problems, taxes, systemic risk, government guarantees, and other distortionary factors), the results of their main model are predicated on the assets of the bank being riskless and are based on a posited objective function that is linear in the percentage of assets funded with deposits. Given this the authors naturally obtain a corner solution with assets 100% funded by deposits. (They have no explicit model addressing what happens when bank assets are risky, but they contend that bank leverage should still be “high” when risk is present.) Given all of this, a much more accurate title for the paper would be:
Why “High” Leverage is Optimal for Banks in an Idealized Model that Omits Many Things of First-order Importance (end Pfleiderer quote)
Sadly, this kind of thing goes on all the time in economics and finance, and theorists in those fields get away with murder because this is the norm. Few from outside the field know enough, or care enough, to point out the utterly unscientific nature of it all. Many economists themselves seem to be quite happy for things to continue this way.
Pfleiderer is an exception. I hope lots of people pay attention. (Hat tip to economist Mark Thoma, whose blog pointed me to this paper).
Follow The Physics of Finance on Twitter: @Mark_Buchanan
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