Equilibrium Models vs. the C-H-B Triad
It’s no secret mainstream economists failed in predicting the 2008-2009 recession and generally have a poor track record when it comes to forecasting.
This time on FS Insider, we spoke with Daniel Nevins, author of Economics for Independent Thinkers: A Practical, No-Nonsense Guide to Understanding Economic Risks, about why that is and how there's a much better way to understand the economy.
What Professional Economists Get Wrong
Based on what we see in terms of forecasting records, many people assume experts fail because the economy is simply unpredictable.
“I would say, let’s not be so fast to throw in the towel,” Nevins said.
The problem has more to do with economists than it does the economy itself, he added.
For the most part, what economists do today is build models, and specifically what are called 'equilibrium models.' Inside these models, the economy is either in or moving toward this idealized equilibrium.
This is the first thing we need to know about mainstream macroeconomic theory, Nevins stated. While we may want economists to answer the big questions about what causes depressions and financial crises, these real-world questions have absolutely nothing to do with an economy that’s assumed to be bouncing back to its equilibrium inside of a mathematical model.
Shortcuts Corrupt Equilibrium Models
To get these models to work (in theory), a large number of assumptions or shortcuts need to be made, none of which reflect the real-world economy.
“The list of shortcuts is very long,” Nevins said. “Their models don’t include balance sheets. That makes it impossible to appreciate the importance of debt...which makes it impossible to appreciate the importance of credit cycles.”
Economists’ standard models and the models used by central banks don’t have any role for banks at all, Nevins noted. They don’t allow any notion of unsustainable spending and they don’t accept that people might spend beyond their means.
In short, these models don’t allow for any of the irrational behaviors that psychologists and behavioral economists study.
So while the average person assumes economists study certain macroeconomic events, the reality is they base most of their work on flawed modeling, Nevins stated.
What Is the Alternative?
Nevins advocates the use of what he calls the C-H-B triad, accounting for the three main sources of volatility: Credit cycles, Human nature, and the Business environment.
Though it sounds fancy, the C-H-B triad is simply a summary of how economists looked at the real world before the economic profession went astray.
Once we understand this, Nevins stated, we’re able to learn from the “renegades of economics,” or heterodox economists who don’t follow standard or orthodox methods.
“The highest level of understanding of economic volatility in my opinion is to sketch out those three areas: credit cycles, human nature, and the business environment, what we’ve learned about each one, and then drilling down from there,” Nevins said.
After we do that, we can appreciate how volatility contributes to the business cycle, rather than try to remove it for the sake of making our models work.
As a longtime professional investor with a focus on proven results, Nevins' book makes a persuasive case against mainstream economic theory and replaces it with something much more useful for money managers, advisors, or those that just want to advance their understanding of the real-world economy.
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