To Formalize, or Not to Formalize

The holy grail of the economics profession is to be able to write down a closed-form, quantitative, formal model that accurately and precisely explains the evolution of the economy. Even though pretty much everyone recognizes that this is pie-in-the-sky, there remains a bias towards models in which all behavior is explained within the context of the formal model, where only the institutions are exogenous. The result is a divide in the profession between economic historians and a minority of straight economists on the one hand, and the mainstream of the profession on the other hand.

The historians and the minority tend to make narrative and "story" arguments about the evolution of the economy, relying heavily on historical facts and circumstances. They allow for complex patterns of behavior and expectations and naturally incorporate policy changes. While they sometimes make allusion to formal models, they rarely spend much time developing them. They can therefore capture broad trends relatively well, but have some difficulty with detailed forecasts.

The mainstream position, by contrast, develops detailed models that tend to incorporate with certainty (which I take to include stochastic rules) the evolution of behavior and expectations. The resulting models can therefore make detailed and precise quantitative predictions, but the simplistic behavioral rules required to make the models tractable cannot capture economically important behavioral and expectational complexities, stories and paradigms.

The solution, I think, is to recognize that expectations, behavior and policy are difficult to model quanitatively but nonetheless respond to economic as well as social variables. That calls for marrying quantitative formal models with the economic history approach: a good economic explanation should include both a formal model that takes these "soft" variables as exogenous and a narrative that explains how these exogenous variables may evolve with the economy. The narrative and formal model can then feed back on each other with the economist as a guide. To put it another way, the narrative informs structural changes in the formal model, and the results of the formal model feed into the narrative.

Production Decisions in the Real World

This is one of the very best economics articles I've seen in a long time. It traces the impact of demand shocks through the global supply chain and shows how the division of labor has created deep information problems that compound uncertainty and fluctuations. It is just crying out for a model based on those phenomena. To me anyway, it suggests that economic fluctuations are likely to be chaotic.

I Love Europeans...

...and the beautiful understated way they have of putting things.

Exhibit A:

"With regards to Europe, because of the methodology, in our view we do not have an entirely convincing analysis," ECB President Jean-Claude Trichet has said.

Translation to Washington-speak: "The analysis is seriously flawed and does not take into consideration many important factors."

Translation to Wall Street-speak: "You're an idiot and your analysis is f***ing garbage."

Negative House Prices

There's been a spate of stories recently that ostensibly demonstrate that in selected markets, house prices are negative; in some cases significantly negative. That challenges an important assumption in many economic models -- what we economists call "free disposal" and "non-satiation."

A rather graphic demonstration comes from Calculated Risk: http://www.calculatedriskblog.com/2009/04/new-homes-demolished-in-victorville-ca.html

Today's WSJ printed this piece about a California town threatening bank executives with arrest if they don't maintain foreclosed homes.

There was another piece a while back, before I started the blog, describing how banks in Indiana are actually walking away from foreclosures because it would cost them more to maintain the house than they would net from a foreclosure.

See this excerpt:

Mercy James thought she had lost her rental property here to foreclosure. A date for a sheriff’s sale had been set, and notices about the foreclosure process were piling up in her mailbox.

Ms. James had the tenants move out, and soon her white house at the corner of Thomas and Maple Streets fell into the hands of looters and vandals, and then, into disrepair. Dejected and broke, Ms. James said she salvaged but a lesson from her loss.

So imagine her surprise when the City of South Bend contacted her recently, demanding that she resume maintenance on the property. The sheriff’s sale had been canceled at the last minute, leaving the property title — and a world of trouble — in her name.

“I thought, ‘What kind of game is this?’ ” Ms. James, 41, said while picking at trash at the house, now so worthless the city plans to demolish it — another bill for which she will be liable.

City officials and housing advocates here and in cities as varied as Buffalo, Kansas City, Mo., and Jacksonville, Fla., say they are seeing an unsettling development: Banks are quietly declining to take possession of properties at the end of the foreclosure process, most often because the cost of the ordeal — from legal fees to
maintenance — exceeds the diminishing value of the real estate...

Ouch.