Theory danger October 15, 2010 at 1:04 pm

Exhibit one, from Ricardo Caballero:

In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons.

Exhibit two, a suggestion for a margin calculation I heard suggested this week:

A high dimensional generalised Pareto distribution model calibrated at 99.9%

Now honestly, dear reader, I am as much in favour of appropriate modelling as the next geek, but this tendency despite everything we have been through to believe that we can model financial systems to a high degree of confidence is profoundly worrying. Caballero has it right: there is a profound confusion of precision in the author’s mind with precision in the real world…

2 Responses to “Theory danger”

  1. Peer review – exactly the measure that you don’t want your teenager using to calculate the best tack to take – is at the heart of all this. Fine for things that don’t matter, like anthropology say.

  2. Anyone who studies basic chemistry or physics learns the distinction between “precision” and “accuracy”. Sure you can write a number down to 20 decimal places — but how many of those digits are “significant”? How *accurately* do they reflect the value you are trying to measure?