Sunday, March 4, 2012

Haugen's Critique of Microfoundations in Finance

In the recent round of criticisms of microfoundations modeling (see, for example, here, here, and here), there's an important criticsim that I haven't seen really hit directly: If you're going to start out micro and aggregate up to a very complicated reality, then it's very hard (at least) to do without making extremely strong, simplifying, and unrealistic assumptions, and that's where the microfondations models can be very unrealistic, and bad for understanding, predicting, and policy.

This issue is in finance too. One of the biggest, and certainly loudest, critics of microfounded finance models is Robert Haugen. Haugen now runs an investment services firm, but he was previously a finance professor at University of California, Irvine, and is #17 on a publications' prestige weighted list of finance's most prolific authors, 1959 -- 2008.

Haugen's criticism is that the aggregate of very complicated, highly interacted, micro behavior can be better understood if you just observe the behavior of that aggregate, rather than trying to understand it, predict it, and make good policy from modeling micro unit behavior and then aggregating up.

In finance, then, you can understand and model the behavior of financial asset markets just by looking at how those markets behave over time, and creating a model to fit that observed behavior. This will get you a much more accurate, realistic, and useful model, than if you make very simplifying assumptions about individual behavior and interaction so that it's tractable to aggregate up to the market as a whole.

So in other words, a model of aggregates can be much more realistic and accurate in describing the behavior of those aggregates because you aren't forced to make extremely unrealistic simplifying assumptions about micro units in order to make aggregating them tractable.

In Haugen's own words:
Chaos aficionados sometimes use the example of smoke from a cigarette rising from an ashtray. The smoke rises in an orderly and predictable fashion in the first few inches. Then the individual particles, each unique, begin to interact. The interactions become important. Order turns to complexity. Complexity turns to chaotic turbulence... ("The New Finance", 2004, 3rd Edition, page 122)

How then to understand and predict the behavior of an interactive system of traders and their agents?

Not by taking a micro approach, where you focus on the behaviors of individual agents, assume uniformity in their behaviors, and mathematically calculate the collective outcome of these behaviors.

Aggregation will take you nowhere.

Instead take a macro approach. Observe the outcomes of the interaction – market-pricing behaviors. Search for tendencies after the dynamics of the interactions play themselves out.

View, understand, and then predict the behavior of the macro environment, rather than attempting to go from assumptions about micro to predictions about macro... (page 123)
For more on this see here.

Now you may reply, Lucas critique! But, as is a theme of this post, let's be realistic. The Lucas critique in many cases relies on people having a ridiculous amount of knowledge, expertise, free time (or little value for the time they must spend analyzing economic, political, and governmental policy, something that few people get much enjoyment from), and self-discipline to have much effect. Sometimes the Lucas effect may be very weak (or slow).

Take a look at surveys of people's knowledge of the governments' budgets and then tell me that it's common for people to accurately, precisely, and regularly adjust their consumption to expected changes in government spending.

In the words of Paul Krugman:
Does this argument sound convincing? It did (and still does) to many economists. Akerloff pointed out, however, that it depends critically on the assumption that people do something that they are unlikely to do in real life: take account of the implications of current government spending for their future tax liabilities. That is, the claim that deficits don't matter implicitly assumes that ordinary families sit around the dinner table and say, "I read in the paper that President Clinton plans to spend $150 billion on infrastructure over the next five years; he's going to have to raise taxes to pay for that, even though he says he won't, so we're going to have to reduce our monthly budget by $12.36."

...the truth is that even families of brilliant economists don't have conversations like this. No, the point is that the effort isn't worth it. If a family has arrived at a sensible rule of thumb for deciding how much to spend, trying to improve on that rule by making sophisticated predictions about the future implications of government spending will improve the families decisions so little that it isn't worth the investment of time and attention.
– "Peddling Prosperity", 1994, page 208.