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Global Ethics Corner: The Power of Economic Models

Friday, April 22, 2011

Economic models become the basis for crucial practical decisions.

Models were at work in the 2008-09 financial crisis. Banks, automakers, and insurers were protected based on assumptions about economic consequences.

You cannot prove a negative. So we'll never be sure if President Obama's decisions prevented the Great Recession from turning into a second Great Depression.

The government bailouts remain controversial because free market advocates see intervention as wrong. Market models clashed with behavioral models. In hindsight, both seem inadequate.

John Authers in the Financial Times notes that "…economics' most basic assumption is flawed,"i.e. the idea that "all other things are equal," and markets are rational. This idea is behind the market model, and contends that, "Nobody has yet come up with a more efficient way to allocate capital than the market."

Authers continues, "Against this came the behaviouralists, who substituted the findings of behavioural psychology for the assumptions of rationality." These assumptions mandate "nudging" markets to correct for human bias and herd behavior.

Both sets of assumptions, market and behavioral, are just that, assumptions. Neither seems adequate. Authers suggests it's time "to break free from this debate and find a new way to model markets."

Yet, our perceptions lag far behind our economic challenges, and the dichotomy continues to animate political rhetoric.

What do you think? Do you accept the free market assumptions? Do you agree with behavioralism and the need to manage markets?

By William Vocke

For more information see:

John Authers, "We Need New Models in an Uncertain World," Financial Times, March 11, 2011.

Bhide, Amar. (2010). A Call for Judgment: Sensible Finance for a Dynamic Economy. New York: Oxford University Press

Frydman, Roman. & Goldberg, Michael D. (2011) Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Princeton: Princeton University Press


Photo Credits in order of Appearance:
Chiva Congelado
Mike McCune
Pete Souza
Public Citizen
EnergeticNYC
Richard Thaler & Cass Sunsteien

Brian Hillegas
RoGb77
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