Elegant Economic Models Versus Ugly Models

The macroeconomic models most frequently used by central bankers are not good and prediction and they may not be very useful for making economic policy decisions.  However, they are mathematically elegant and several Nobel Prizes have been awarded to economists who developed the models.  Mathematical elegance appears to have prestige value even when it is not useful.  Some would like the social sciences to be more like physics which is regarded as the real science.

Even in physics, however, elegant models are not very useful in explaining the messier world in which real things get done.  For example, there are no equations that can describe the operation of a nuclear reactor.  On the other hand, crude computer simulations are able to do a decent job of predicting weather patterns.  That may be a more promising path for economists to pursue.  An example is given of a simulation which did a better job of describing the real estate boom than the macroeconomic models that are commonly used to make economic policy decisions.  The macroeconomic models were recently used to argue that the housing boom was caused by central bank policies which kept interest rates low.  The computer simulations found that the interest rate effect was small in relation to the leverage effect.  The ability to purchase a home without a down payment was the major cause of the housing boom.  It opened the market to a huge number of potential consumers who had no savings. 

While this article makes the case for messy computer simulations.  I wonder how necessary they are.  Almost any real estate agent would have made the same prediction.  Cutting interest rates has the effect of reducing monthly payments.  That will expand the market for those who have enough cash to make a down payment.  But it does little to open the market up to the vast number of households with inadequate savings for a down payment.  Moreover, the low interest rates were not as important as teaser loans that artificially lowered interest rates for the first few years of the loan.  It does not require a whole lot of science to explain the real estate boom.