Continuing the analysis of interest rates
For economists, a model is not a toy train or runway star, but rather, a simplified description of reality, usually involving equations. It’s a way to describe how the parts of the world (or at least the financial markets) fit together. Our new approach to estimating inflation expectations starts with a model of real and nominal interest rates—in effect making assumptions and writing down equations that purport to describe how interest rates and inflation move over time.2 The model has two key parts. The first describes how short-term real interest rates and inflation move over time. The model has to capture movements of short-term rates accurately in order to describe the behavior of all interest rates accurately: If short-term rates rise, do they stay high or quickly fall; do they move smoothly or take a few big jumps? The second part of the model describes how those movements in short-term rates and inflation build up and determine longer-term interest rates and expectations.
The Quants invaded Wall St many years ago, and seemingly, even after numerous abject failures, their influence remains. Why is mathematics so dominant within Finance and Economics?
In relation to economics, its statements and propositions are not derived from experience. They are, like those of logic and mathematics, a priori. It is this characteristic of economics, that led to mathematics dominating the way in which economics is investigated, which has led directly to economics losing its way.
This takes us into the realms of philosophy where we consider analytic and synthetic statements coined originally by Kant.
The analytic statement, by definition, is known a priori. The synthetic statement however may not be. In economics however, there is a synthetic statement that is known a priori.
Mises’s “axiom of action” — the proposition that humans act — is a true synthetic a priori proposition. The proposition that humans act cannot be refuted. Even if we were to assume Poppers’ Theory of Falsification, where one example of the null hypothesis is enough to disprove the hypothesis – can an example be found of a non-acting human being?
Mathematics, as previously stated, is an analytic statement, and therefore by definition, a priori. Why then does mathematics get economists into trouble?
First, mathematic axioms are unchanging. 2 + 2 = 4 This is true, and will always be true. Numbers relate to one another in an unchanging set of rules, mathematical axioms.
People however are inaminate objects that can be investigated, through experiments, experiments that utilise mathematics as a primary tool to measure the minutest quantitative detail. Every day, people learn, adopt new values and goals, and change their minds; people cannot be slotted and predicted as can objects without minds or without the capacity to learn and choose. People can and will act at times, against their logical best interests, people are random in their actions, yet, will herd at others. The reasons for these anomalies are/have been investigated in Behavioural Finance
The methodological approach taken by today’s mainstream economics — following those applied in the field of natural sciences — is empiricism. However, this approach is incompatible with economics, as no laboratory experiment can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged.
First, empirical tests are based on historical data, which must form the basis of the empirical approach to social science. These data are contingent, as they are always the result of complex phenomena. The models proposed are based on modeling historical data. This implicitly assumes that past actions, are deterministic of future actions, which we know to be false.
To be continued.
