Models don’t lie, incorrect assumptions do

Snarl

An engineer, a physicist and an economist are stranded on a deserted island with nothing to eat. A crate containing many cans of soup washes ashore and the three ponder how to open the cans.
Engineer: Let’s climb that tree and drop the cans on the rocks.
Physicist: Let’s heat each can over our campfire until the increase in internal
pressure causes it to open.
Economist: Let’s assume we have a can opener.

In a recent paper titled Chameleons: The Misuse of Theoretical Models in Finance and Economics Paul Pfleiderer of Stanford University lays out how some models, built on assumptions with dubious connections to the real world, end up being used to inform policy and other decision making. He terms these models “Chameleons.”

Notice how similar these two abstracts are:

To establish that high bank leverage is the natural (distortion-free) result of intermediation focused on liquid-claim production, the model rules out agency problems, deposit insurance, taxes, and all other distortionary factors. By positing these idealized conditions, the model obviously ignores some important determinants of bank capital structure in the real world. However, in contrast to the MM framework – and generalizations that include only leverage-related distortions – it allows a meaningful role for banks as producers of liquidity and shows clearly that, if one extends the MM model to take that role into account, it is optimal for banks to have high leverage.

– “Why High Leverage is Optimal for Banks” by Harry DeAngelo and René Stulz.

To establish that high intake of alcohol is the natural (distortion free) result of human liquid-drink consumption, the model rules out liver disease, DUIs, health benefits, spousal abuse, job loss and all other distortionary factors. By positing these idealized conditions, the model obviously ignores some important determinants of human alcohol consumption in the real world. However, in contrast to the alcohol neutral framework – and generalizations that include only overconsumption-related distortions – it allows a meaningful role for humans as producers of that pleasant “buzz” one gets by consuming alcohol, and shows clearly that if one extends the alcohol neutral model to take that role into account, it is optimal for humans to be drinking all of their waking hours.

– “Why High Alcohol Consumption is Optimal for Humans” by Bacardi and Mondavi 😉

These are a good illustration that one can generally develop a theoretical model to produce any result within a wide range.

Read the whole thing at your leisure: Chameleons: The Misuse of Theoretical Models in Finance and Economics

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