Simple Principles Are Better Than Complex Models

|
Posted: May 06, 2020 10:40 AM
Simple Principles Are Better Than Complex Models

Source: AP Photo/Ted S. Warren

Modern mainstream economics tends to involve complex mathematical models that purport to forecast the future from past results, in close enough detail for politicians to make decisions that affect the economic well-being of an entire nation and even the world. They have, however, proven no better at predicting key turns of events than the average man in the street. The irony is that many economists have forgotten or totally ignore basic economic principles when building the models. Some even consider them quaint, outdated, or simple-minded.

Basic economic principles, however, are neither simplistic nor simple minded. They are, rather, quite sophisticated in their simplicity, much like Newton’s laws of physics are. They are the result of centuries of observation and thought by astute observers and systematic thinkers. They are, in fact, logical necessities arising from the differences between individuals, their abilities, interests, physical characteristics, preferences, and so on. People act in their self-interest and self-preservation. In other words, they expect to be better off after their actions than they were before, even if being better off means securing a place in heaven, saving face against critics, or being considered a good person.

Many of those things are important factors in all decisions, whether or not money is transacted. Most of our interactions with others don’t involve money or any other measurable value, and thus, they cannot be displayed in monetary terms that can be accumulated into national statistics. That is the fatal flaw in national economic modeling and analysis. As F. A. Hayek said in his Nobel acceptance speech, that kind of thinking leads to a pretense of knowledge, ignoring everything that doesn’t fit into clever mathematical formulas. In Hayek’s words, “I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretense of exact knowledge that is likely to be false.” There is a lot of falsehood parading as knowledge. Most of what happens is not measurable in terms of dollars.

Economic laws, such as supply and demand, are typically presented as comparing quantities to prices in terms of money, with higher dollar prices inducing lower quantities demanded. That, however, is just for convenience. Everyone understands money prices, but price in reality means opportunity cost, everything you have to give up to get what you want. Because everyone has different circumstances and preferences at any given time, every individual’s opportunity costs are different. Some people, because of particular circumstances and preferences, would buy an item even at a high price or opportunity cost, whereas others would need a low opportunity cost before they value what they get more than what they have to give up.

True economic principles are simply descriptions of reality. They describe the interactions of human beings with different preferences and limited resources. The reason that most politicians and many modern economists downplay such principles is that they demonstrate the negative consequences of political interference in the economy. It is understandable that there were empty shelves in stores across the United States in response to coronavirus last month. Throughout the country, populist, do-gooder politicians at all levels promised that they would severely punish “price gougers,” as though that was a virtue. That is, at its very essence, maximum price controls, which inevitably lead to shortages. It is also understandable that Canada did not suffer from such empty shelves. According to a Canadian lawyer quoted by the American Institute for Economic Research, Canada’s competition laws generally don’t interfere with the free market. 

Economic principles are powerful, but economies are complex adaptive systems, much like a biological systems. You can try to understand them, but when you interfere with them, there will usually be negative consequences. Thus, economists who curry the favor with politicians must ignore them.