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Some Economic Models are Alluring, Others are Useful

In some markets, prices are affected by market forces and in others, like the job market, they are not

Statistician George Box is credited with the aphorism, “All models are wrong, but some are useful.” Unfortunately, as the brilliant economist Ed Leamer, once quipped, “Economists are like artists. They tend to fall in love with their models.” A large part of the art of economics is distinguishing between attractive models and useful models.

The traditional bedrock of economics is the demand-and-supply model. Every introductory economics course explains how demand and supply are related to price and how the equilibrium price is where demand is equal to supply. This can be a very useful model for predicting how changes in demand and supply affect prices and trades — if we make the tempting assumption that the market price is equal to the equilibrium price.

Prices do respond quickly to changes in demand and supply in some markets — the stock market is a prime example — but prices in other markets are little affected by market forces — and often leave substantial gaps between demand and supply. The labor market, for example, is not at all like the stock market. If a newly minted PhD from an elite university were to contact a college dean and offer to take the job of a current professor for a 10% lower salary, the dean would, at best, put the resume on file and offer to be in touch if a position opens up. Professors with jobs do not have to take pay cuts to fend off replacements. There is no daily auctioning of jobs for professors or most other occupations — which can leave job seekers unemployed or employed in jobs for which they are wildly over-qualified.

There are good reasons for job security and sticky wages. Would you move to a new city and take a job with a new company if you were in constant danger of having your job auctioned off to the lowest bidder? Yet, historically, economists treated the labor market as if it were an auction market in equilibrium. Everyone who wants to work at the prevailing wages has a job. Those who are unemployed choose to be unemployed.

There’s more. Labor demand in this model is determined by labor productivity and labor supply is determined by workers’ willingness to sacrifice leisure for work. Wages are set so that labor demand is equal to supply and prices are set so that everything workers produce is sold. Output is what it is. Monetary policies, for example, can affect prices but not output or employment.

The Great Depression in the 1930s laid bare the folly of this model. Millions lost their jobs, their homes, and their businesses and they did not do so voluntarily. Looking at the carnage, John Maynard Keynes (1883–1946) wrote that,

… professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation… It may well be that the classical theory represents the way in which we should like our economy to behave. But to assume that it actually does so is to assume our difficulties away.

The half-hearted retort by classical economists was that wages and prices will find their equilibrium values in the long run, to which Keynes famously replied,

In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.

The Great Depression lasted a decade, ended only by World War II. Keynes’ argument won the day and led to the creation of a new field, called macroeconomics, that tries to explain fluctuations in inflation, interest rates, and unemployment. In Keynesian models, in the absence of supply bottlenecks, output is affected by the demand side of the economy in general and by monetary policies in particular. If the Fed cuts interest rates for example, people will borrow more money in order to buy homes and homebuilders will hire more workers to build homes. Currently, the demand for homes is slumping and so are home building and construction jobs.

Unfortunately, by the 1970s, memories of the Great Depression had faded, dissatisfaction with government policies had grown, and there was a resurgence of interest in classical economics. The “new classical macroeconomists” emerged, arguing once again, against all reason and evidence, that all unemployment is voluntary. Incredibly, the new classical models assumed that fluctuations in the unemployment rate are caused by workers’ not knowing the prices of what they buy with their wages. Sometimes, they underestimate how expensive things are and take jobs they later regret having taken. Other times, they choose to be unemployed because they do not know how cheap things are. When workers realize their mistake, things return to normal. No, I am not making this up. The Great Depression was evidently a decade of people refusing to work because they overestimated prices!

Lawrence Summers/CC BY-SA 3.0

These new classical models are laughable except for the fact that many economists took them seriously. The profession eventually came to its collective senses and most economists now acknowledge that fluctuations in employment are not entirely voluntary.

Alas, some are still enamored with classical market-equilibrium models. Lawrence Summers, whose name can seldom be spoken without the adjective “brilliant,” was recently interviewed by Ezra Klein:

I think that’s right in part, but I think it restates what I think is a bit of a popular confusion in the following sense — supply is what it is. Monetary policy can’t change it. Fiscal policy can’t change it, except in the long-run… So the job of the demand managers, principally the Fed, is to judge what supply is and calibrate appropriately.

Here, as with his unrepentant enthusiasm for financial deregulation, Summers is seduced by the allure of market-equilibrium models.

Nobel laureate Paul Krugman recently said that

James Tobin stands out among modern economists for his ability to use the standard economic concepts, like maximization and equilibrium, without being their prisoner—he knew when to tone down the rigor and let observation override purism. This allowed him to swim against the tide on at least two crucial issues: the role of monetary policy and the causes of inflation. And his vision has been overwhelmingly vindicated by events over the past 15 years.

We can all be thankful that President Barack Obama did not follow through on his promise to make Summers chair of the Federal Reserve and instead chose a Tobin disciple, Janet Yellen, who knows that some economic models are alluring, others are useful.

You may also wish to read: The AI illusion – State-of-the-art chatbots aren’t what they seem. GPT-3 is very much like a performance by a good magician. You can thank human labelers, not any intelligence on GPT-3’s part, for improvements in its answers. (Gary Smith)

Gary N. Smith

Senior Fellow, Walter Bradley Center for Natural and Artificial Intelligence
Gary N. Smith is the Fletcher Jones Professor of Economics at Pomona College. His research on financial markets statistical reasoning, and artificial intelligence, often involves stock market anomalies, statistical fallacies, and the misuse of data have been widely cited. He is the author of The AI Delusion (Oxford, 2018) and co-author (with Jay Cordes) of The Phantom Pattern (Oxford, 2020) and The 9 Pitfalls of Data Science (Oxford 2019). Pitfalls won the Association of American Publishers 2020 Prose Award for “Popular Science & Popular Mathematics”.

Some Economic Models are Alluring, Others are Useful