Tuesday, January 10, 2012

Economic forecasts: calibration problems

I liked the following piece because of the highlighted one liner.

Why Economic Models Are Always Wrong
David H. Freedman, Scientific American, 26 October 2011 (hat tip: Big Picture).

The next step [is] "calibrating" the model. Almost all models have parameters that have to be adjusted to make a model applicable to the specific conditions to which it's being applied--the spring constant in Hooke's law, for example, or the resistance in an electrical circuit…

That financial models are plagued by calibration problems is no surprise to Wilmott--he notes that it has become routine for modelers in finance to simply keep recalibrating their models over and over again as the models continue to turn out bad predictions. "When you have to keep recalibrating a model, something is wrong with it," he says. "If you had to readjust the constant in Newton's law of gravity every time you got out of bed in the morning in order for it to agree with your scale, it wouldn't be much of a law But in finance they just keep on recalibrating and pretending that the models work."

If economics went back to treating itself as more of a social science, in the manner of Adam Smith for example, they would probably get more useful results. My suspicion is that there is an illusion of precision because of the available pricing data and monetary data: The supposed fungibility of money.

Economics is very tied into a world view that supports the current status quo. Since a social science is often working within a certain system, that does not always lead incorrect assumptions, provided you stay within the system. But we seem to be working within a collapsing paradigm. We have had a recovery with no additional employment, and have a couple of looming crises (European Debt, Chinese Property bubble) still to play out. Small Holding’s comments about his employer ramping up production implies that they listened to the mainline economic forecasts: that does not seem to be working very well for them.

My personal philosophy –occasionally acted on- is to be very cautious. Avoid long term commitments (debt) and be suspicious of others’ long term commitments (ss, pensions) as well. As best as you can afford, prepare for the worst and hope for the best.


PioneerPreppy said...

as an interesting side note. Although they did ramp up production which was because they had let alot of inventory dwindle but also because we had a greater number of employees that needed to be kept busy. When we had our annual company financial review the local CEO type put it off for almost 2 quarters and then will only give figures for the first two quarters of 2012 business. It is like 2011 business will not be admitted to or reproduced.

My bet is 2012 is going to be just as bad in the end however.

russell1200 said...

I changed where I work recently. Central North Carolina does seem to be picking up a little bit. Since we always have a flood of new people coming in, our unemployment rate won't probably drop drastically for a while.

In construction you can see the bills going unpaid. It has always been a rob from Peter to pay Paul business. But if the losses get too high, or the flow of new business dries up...

In manufacturing I suspect you start seeing new suppliers?