January 23, 2022

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Why economic models can’t be trusted during a crisis

Adam Applegarth was chief executive of the then high-flying Northern Rock. He said his company was outstripping his competitors because he was implementing a business model for mortgages which meant he could grow much faster.

And he was right until he wasn’t. Northern Rock went bust.

The world is full of economic models, some of which are good, some of which are bad, some of which are useful. But they have a fatal flaw. Too many people — be they businessmen, politicians, regulators, consultants, pension trustees, academics, journalists and yes, economists — treat these models as gospel. Yet, as Northern Rock showed, they are not.

John Kay and Lord (Mervyn) King try to show how economists have got it so wrong in their prescient new book Radical Uncertainty — How we make good decisions in a radically uncertain world.*

They are, of course, economists themselves — Kay being at one time Director of the Institute of Fiscal Studies and the first head of the Said Business School in Oxford; King, the chief economist in the Bank of England and later its Governor. But they despair of the blind alleys into which so many of their profession have gone.

Instead of seeing if a model helps reveal some fact or trend which might otherwise have been obscured, users think that the model represents the real world. Instead of seeing how much of the model relies on assumptions, and how many of the figures are made up, its users embrace it. Instead of being a single, static, unworldly illustration of a complex and unknowable reality, the users treat the model as fact, assume it will continue forever, and tell their employees to follow it. They think risk can be contained, but they don’t reckon on uncertainty.

They implement the models in business, regulation, politics or wherever, thinking the model is broadly true and where all risks are known. But the authors say: “We do not make good decisions by professing knowledge we do not have.” The results in business, politics and society at large when they do are often, indeed usually, disastrous.

The range of the authors is breath-taking. People may have heard of one or two economists — Keynes, for example, or Adam Smith. This book also seems to reference most of the economists in between. And in most the authors show how these economic modellers (or their disciples) have unreasonable assumptions where they think among other things that the economy is static, and the people rational.

It is rather like thinking of how installing a traffic light will make things better without having any concern for the volume of cars, the time when drivers travel, opting to walk, cycle or give up the commute entirely, or whether drivers will take a different route which might make things worse.

They think models can be manipulated to say what the person in charge wants them to say, and explain why many academic economists go along with this and produce false research.

Normal people often don’t do what economists expect. Normal people don’t put money above everything else. Normal people tend to ask a friend, family or colleague and look at what happened before if they don’t know something.

They work, enjoy life and hone their ideas in social groups rather than being out for themselves. Normal people don’t take unreasonable risks. Normal people use conversation, narratives and experience — their own or others’. They cope with radical uncertainty. They don’t invent a model to say these things don’t happen.

Thus the authors are sceptical of Milton Friedman and the Chicago School; of shareholder value; of the efficient market theory, of HS2; management away-days, profit maximisation, pension de-risking, reasonable expectations, and executive bonuses.

All this is lost on economists except out of academia when they come up with real life. Harry Markowitz, of the Chicago School, got the Nobel Prize for his efficient portfolio theory. But he did not follow his own advice.

Talking of his own decisions for his retirement fund he said: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead I visualised my grief if the stock market went up and I was not in it, or if it went down and I was completely in it. My intention was to minimise my future regret, so I split my contributions 50/50 between bonds and equities.”

Radical Uncertainty by John Kay and Mervyn King (Bridge Street Press)

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