The Pretense of Finance
By Kyle Fowler
In this episode of EconTalk, Russ Roberts hosts Lars Peter Hansen, Professor of economics at the University of Chicago and a recipient of the Nobel Prize in Economics. Roberts and Hansen discuss the validity, shortcomings, and use of economic models in understanding systemic financial risk.
Hansen reminds us that it is irresponsible to place 100% confidence in models to solve economic problems. Roberts mentions F. A. Hayek’s 1974 Nobel Address “The Pretence of Knowledge”, in which Hayek argued that attempts to model the economy give the illusion of science. Hansen agrees with Hayek that overconfidence in quantitative modeling is dangerous, but argues that models are useful in understanding our economic system and guiding policy if they are used sensibly.
1- To what extent do you agree with Hansen that it is irresponsible for lawmakers and government officials to place their full trust in models to solve economic problems? Do you agree with Hayek’s view that attempts to model the economy create a false illusion of science, or do you agree with Hansen’s opposition that models are useful in understanding economics and guiding policy? Why? Where do you think the line should be drawn between using qualitative and quantitative analysis to understand economics and make policy decisions?
2- Roberts and Hansen concur that politicians have a tendency to embrace economists who share their viewpoints. Hansen views this as problematic, as it leads politicians to advocate for economic policy based on their opinions rather than on data.
How can politicians lacking education and work experience in economics legislate economic policy in a way that reflects data rather than their personal biases?
3- Roberts argues that in a financial setting, it is possible that quantifying risk could deceive financial professionals into thinking that risky financial practices are safer than they actually are. Removing quantification in the financial sector could lead to reliance on theory for risk management procedures. Hansen argues that fully relying on theory to measure financial risk would eliminate useful parameters in decision making that economic models provide.
Should financial professionals rely on quantitative or qualitative factors in measuring risk? If both quantitative and qualitative factors can provide useful parameters in measuring financial risk, which should be prioritized, and why?
4- Hansen proclaims that economic models are always wrong in some sense, meaning that there will always be some uncertainty. Hansen contends that in spite of the uncertainty that models fail to overcome, they are able to estimate probabilities of what can happen in the future, and can always be improved upon.
If economic models are always wrong in some sense, to what extent can they reasonably be relied upon to make market predictions and mitigate risk? Are economic models or existing empirical data a better means of analyzing and predicting the future of the economy? Do you think that existing economic models adequately hypothesized the recent failures of Silicon Valley Bank, First Republic Bank, and Signature Bank?
5- Hansen claims that the Dodd-Frank Act initiated a new government practice of designating which firms and businesses are systemically important. Hansen fears that when firms have been designated as systemically important, they are incentivized to take more substantial risks. Hansen concludes that when firms fear the risk of failure, they behave better.
With reliance on government bailouts, have some firms been given an unfair advantage and been incentivized to take unnecessary risks? Are some firms and industries so essential to our economy that they should be protected by the government from failing under any circumstances? If so, which ones, and why? If no, why not?
[Editor’s note: This Extra was originally published on June 16, 2023.]
Kyle Fowler is a student at Indiana University studying Accounting and Finance and is a 2023 Summer Scholar at Liberty Fund.