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Why Economic Models Are Always Wrong

samzenpus posted more than 2 years ago | from the soft-science dept.

The Almighty Buck 676

mayberry42 writes "Did you ever wonder how and why professional economists often seem to get it wrong in terms of predicting consequences or policies accurately (or even at all)? Or how very few even saw the current economic collapse? This article provides an interesting, if obvious, reason as to why economic models are effectively always wrong."

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Obvious really (4, Interesting)

BeerCat (685972) | more than 2 years ago | (#37852892)

Most economic models are based on "how we would like people to act" rather than "how people actually act". Much of the time, the model works, but they fail when people act in irrational ways.


Even rational models are unstable (5, Interesting)

Mathinker (909784) | more than 2 years ago | (#37852948)

Even if everyone acted rationally, you would then have the instability which is generated because all of these rational people would then change their behavior based on ... the model. It's unclear, and in my eyes rather unlikely, that a "fixed point" exists where all of these rational people start behaving identically and predictably.

The unpredictability doesn't only come out of irrationality. If you look at game theory, you see that many optimal (i.e., rational) strategies are "mixed" strategies where the rational party necessarily behaves probabilistically, not deterministically.

Re:Even rational models are unstable (0)

Anonymous Coward | more than 2 years ago | (#37853054)

if everyone acted totally rationally everyone would run out of food at the same time.

Re:Even rational models are unstable (2)

TheInternetGuy (2006682) | more than 2 years ago | (#37853096)

No they wouldn't, because there is a limited amount of forks you see. Haven't you ever heard about Dijkstra's dining philosophers problem?

Re:Even rational models are unstable (1)

LordNacho (1909280) | more than 2 years ago | (#37853316)

This is the real, underlying answer, and also the reason why a number of social science disciplines cannot reach the level of rigor of the hard sciences. Basically, whatever your subjects think about how the world works affects how they behave (ie how the world works).

Have a look under Soros and reflexivity for how this applies to financial markets.

Re:Obvious really (3, Interesting)

Anonymous Coward | more than 2 years ago | (#37852956)

Yep, most economic models do not take actual human action into account. There are some economists that do consider human action, though (and even consider it the foundation of economics). Interestingly, those economists were the ones that did predict the current economic collapse, but were pooh-poohed and marginalized for their views.

Re:Obvious really (-1)

damburger (981828) | more than 2 years ago | (#37853012)

There are getting on for 7 billion people on this planet, each of them too complex for even one of them to have their behaviour modelled (see the lack of any AI for details). Any economist who claims to be taking into account human action is taking complete bullshit, and anybody claiming their favourite economist makes accurate predictions is counting the hits and forgetting the misses.

Re:Obvious really (2, Insightful)

The Master Control P (655590) | more than 2 years ago | (#37853184)

There are getting towards 10^23 molecules of gas in this two liter bottle, each too complex for its equation of motion to be solved alone. Any physicist who claims his model to be taking into account atomic behavior is talking complete bullshit, and anybody claiming their favorite equation of state makes accurate predictions is counting the hits and forgetting the misses.

Or, statistical predictions don't require knowing the exact behavior of each agent, and expectation values can take you a long way.

Re:Obvious really (5, Insightful)

Arlet (29997) | more than 2 years ago | (#37853248)

Nice analogy, but physicist don't have to worry that the CEO molecule in an apple might die.

Re:Obvious really (0, Troll)

damburger (981828) | more than 2 years ago | (#37853302)

An idiot comparing molecules to human minds gets modded 'Insightful'?

Statistical mechanics works because when molecules interact they do so in probabilistic ways that you can easily work out. Humans don't operate like that. Human interactions are, shockingly, more complex than a molecule bumping into another.

Re:Obvious really (2)

Hognoxious (631665) | more than 2 years ago | (#37853198)

You don't need to be able to track individual molecules to apply the gas laws.

Most people are rational enough for most of the time; if you have enough of them the individual irrationalities are just noise.

The problem is that most of the models' parameters (if they represent anything measurable at all) are at best approximations, and at worst guesses. And yet because the answer has 93 decimal places and pops out of a computer people believe it.

Re:Obvious really (-1, Flamebait)

damburger (981828) | more than 2 years ago | (#37853310)

Another retard thinking he understands physics (rather than knows physics).

Statistical mechanics works because molecule A is the same as molecule B, repeat for 10^23 molecules. You cannot characterise people in that way, as evidenced by the outstanding success of statistical mechanics, and the outstanding failure of economics.

Re:Obvious really (1)

Jane Q. Public (1010737) | more than 2 years ago | (#37853346)

"...if you have enough of them the individual irrationalities are just noise."

Unfortunately, that is not so, as the many blogs by OWS protesters show. Many of them, bizarrely Michael Moore-like, have been claiming that "capitalism" is the enemy.

To borrow the words of Founder James Madison: there are "a plethora of proofs" that this is not so, and the issues that Occupy Wall Street are protesting are a result of lying, cheating, and corruption of the system, not the system of capitalism itself.

But again: enough of them have been saying "capitalism is the enemy" to make it clear that many of them believe it, no matter how untrue it may be.

And perhaps that is not a model of "random" rationality, but rather a reflection of "strange attractors" instead. After all, there ARE people trying to sway the protests to their own purposes.

Re:Obvious really (1)

gomiam (587421) | more than 2 years ago | (#37853234)

There may be a difference between modelling individuals and modelling crowds. If that is the case, modelling human groups actions may not be as wrong as you make it to be.

Economy is a religion, not a science (5, Insightful)

captainpanic (1173915) | more than 2 years ago | (#37852996)

In a religion, you just tell people what is the Truth. In science, you try to observe and learn.

The models are self fulfilling prophecies.

The high priests of the Economy tell us the Truth. The lower priests spread the word. And the people believe. Without the belief of the people, the system would instantly collapse. And if reality turns out differently, then they/we just invent a New Truth.

I mean, is it really necessary to give trillions of euros/dollars to banks to bail them out? In which pockets is that money disappearing? The bailouts are presented as "The Only Way"... but nobody actually knows.

Re:Economy is a religion, not a science (1, Insightful)

Jane Q. Public (1010737) | more than 2 years ago | (#37853206)

That is the only possible explanation for the persistence of Keynesian economics in America, since it demonstrably hasn't worked since 1913.

Wait... I wrote "only possible". That's not true. Another possible reason for its existence is that it gives the rich and the politicians instant access to virtually unlimited, as-yet-uninflated dollars at somewhere between low and no interest.

Well... whichever one you think is the greatest cause. Whatever that may be, it certainly isn't viable as a real economic theory.

Re:Obvious really (3, Interesting)

mikael_j (106439) | more than 2 years ago | (#37853010)

Ah, to quote an economist acquaintance of mine "Economics isn't about numbers, it's just psychology on a mass scale" and "In school they teach us that everyone is a rational actor but everyone is completely irrational and refuses to admit it because then their models wouldn't be accurate".

Re:Obvious really (1)

hitmark (640295) | more than 2 years ago | (#37853046)

Never mind that in economist modeling, rational means accurately predicting future events. Anywhere else, that would be known as clairvoyance...

Re:Obvious really (0)

Anonymous Coward | more than 2 years ago | (#37853126)

"...but they fail when people act in irrational ways."

When people don't act irrationally? Maybe something like 1% of the time being...

Re:Obvious really (4, Insightful)

janimal (172428) | more than 2 years ago | (#37853150)

Just ask Derren Brown if people are predictable. If you think people cannot be modeled, you are deluding yourself. Adam Smith saw it, and came up with a revolutionary theory that worked. Amazingly enough, his model assumes that all people act in their own self interest.

Of course, the way you interpret the 'self interest' is what varies, but I am pretty sure that for the majority of humans self interest is fairly narrowly defined.

Saying that every human is unique and special is like saying you're immune to commercials. It's just wishful thinking.

See comments below. The crash was predicted. People acted in a predictable way.

Re:Obvious really (1)

somersault (912633) | more than 2 years ago | (#37853296)

Saying that every human is unique and special is like saying you're immune to commercials. It's just wishful thinking.

Uhm.. what if every time you see a commercial (which for me is pretty much only whenever I go to the movies) you're just sitting there cynically wondering wtf the marketing droids were smoking? Why the hell would I buy an intel soundcard just because this popular artist plays his song in the commercial? Why would I destroy my health by eating sugary shit just because happy sexy people on a screen are eating it?

I wouldn't say I'm immune to all forms of marketing. Viral marketing probably gets me sometimes. I do tend to be very critical of hype in general though, until I've tried stuff for myself, or read some reviews from people who've actually used the product/played the game/whatever.

Re:Obvious really (1)

vtcodger (957785) | more than 2 years ago | (#37853306)

Most of the comments in this thread are accurate enough (or at least defensible), but miss the point of the article. The claim in the article is that even if one gets everything right in their model's math and needs only to compute a few constants, the constants will be miscomputed. Personally, I don't have any trouble at all with the thesis that economic models are all -- each and every one -- wrong. That seems to match experience pretty well.

I do have considerable problem with the claim that seems to be made that even with perfect data one can't precisely compute the parameters defining a simple model like a straight line or exponential curve. That really seems a most extraordinary assertion and I really don't see anything that supports it.

Overfitting data (0)

Anonymous Coward | more than 2 years ago | (#37852896)

I believe these two words effectively summarize the article. Either simplify the models to decrease the number of parameters, or collect more data. There is also the fact that the models are probably time varying, which makes data collection much much more difficult of course.

Gaming the system (2)

initialE (758110) | more than 2 years ago | (#37852912)

I think the article is missing another key factor - the fact that people abuse the system to their benefit.

Could psychohistory be the answer? (2)

afranke (1400099) | more than 2 years ago | (#37852898)

I wonder if that could apply.

Re:Could psychohistory be the answer? (4, Informative)

janimal (172428) | more than 2 years ago | (#37853220)

1. The economists, who were correct were not listened to. (just look up Peter Schiff's predictions and how he was ridiculed)
2. The economists, who were wrong were listened to, because that's what everyone *wished* were true.
3. If anyone was in a position to personally gain from what was going on, they would most likely not have stopped it. So even if there were potential whistleblowers among the bankers and brokers, their incentive structure made whistleblowing a dumb move. If everything is going to s**t and you know it, but are in a position to set yourself up for life from the situation, or risk your job and your retirement saving a train that you probably couldn't stop anyway... what do you do? Be honest with yourself.

Re:Could psychohistory be the answer? (1)

EdZ (755139) | more than 2 years ago | (#37853232)

Not really. Psychohistory (and actual group psychology) rely on LARGE groups of people to allow reasonable modelling. Very large, so the effect of individuals on the group is minimised. Small groups are much more affected by the actions of individuals which makes modelling much harder if not impossible. Unfortunately, large amounts of the global economy is controlled by a few very small groups, so one person doing something blithering stupid will, instead of being an unnoticeable blip in an average instead cause an enormous company to go under.

Re:Could psychohistory be the answer? (1)

Jane Q. Public (1010737) | more than 2 years ago | (#37853308)

Yes, but as "janimal" points out, very large numbers of people fell for this very thing. They were being told -- by very interested parties -- that everything was wonderful. The people who were disinterested but correct, were ignored because their message was not pleasant.

So, in pied-piper fashion, vast numbers of Americans were led to make bad investments. Because they were told it was okay. Because the people telling them that it was okay were the financiers and the government, who they were brought up to trust.

If that isn't mass psychology, I don't know what is.

It was the recognized authorities who were performing the stupid acts (as we can see, indisputably, in hindsight). Not the others, who made the accurate predictions and who were laughed at by the "experts" (see the Peter Schiff video) and ignored.

I daresay this is a mass psychological phenomenon on it's own: the blind following of "authority" even over a cliff, much like the (untrue) legend of the lemmings, rather than take the effort to research and think for oneself.

Economics... (3, Insightful)

blahplusplus (757119) | more than 2 years ago | (#37852900)

... is not a science. The legal structure of money, the way prices work in a one way fashion, and private ownershp are all political all the way through. Now this may piss off Americans but there are alternative ways to organize society whether they like it or not. Human beings tend to be people of their era and they often have a profound lack of imagination, the black and white right/left thinking I see from people already disqualifies them for not even having the courage to analyze or think about the structures and societies in which they find themselves, the false notion that it is either THIS/THAT, BLACK/WHITE is having given up critical thinking and analysis for good.

Re:Economics... (5, Insightful)

Hognoxious (631665) | more than 2 years ago | (#37852958)

Actually plenty of economists did predict the crash. It's just that the only way to prevent it would have been to stop the party, and any politician who'd done so would have been replaced by someone who'd allow the credit-fueled binge to continue.

Re:Economics... (1)

Totenglocke (1291680) | more than 2 years ago | (#37853138)

Quite true, there were plenty of Economists who predicted the crash - the only problem is that you can't force people to listen. So instead those who predicted the crash (and the minority who listened to them) saved up and prepared so that they wouldn't get stuck losing their home when everything went bust.

Re:Economics... (2)

blahplusplus (757119) | more than 2 years ago | (#37853142)

"Actually plenty of economists did predict the crash"

Crashes are inherent to the nature of capitalist society and has been known about since the time of marx and even before then. Just because you can predict something doesn't say anything about the political foundations of the institutions and social relations in general. I can use science to predict the whether tomorrow will be sunny, but that is different from human societies which are organized on the basis of legal and political structures. Money, property and the laws governing it are human inventions not natural laws.

Re:Economics... (5, Informative)

Jane Q. Public (1010737) | more than 2 years ago | (#37853246)

Not entirely true. Ron Paul, who until now has always been pushed aside as irrelevant to the party, predicted it clearly and concisely. He predicted what would happen, approximately when, and exactly why. And all three of those came to be. ("When" was of course inexact... nobody is claiming clairvoyance here.)

More to the point, he predicted what would happen afterward, which has also been coming to pass.

Peter Schiff, who is also of the Austrian school of economics, publicly predicted the same, back in 2006-2007. There is a great YouTube video of him arguing with Keynesians who were all basically saying "The economy is fine!"

But of course, he's not a politician. Yet.

Re:Economics... (1)

Hognoxious (631665) | more than 2 years ago | (#37853336)

I said plenty of economists predicted it - that's true.

I said politicians didn't do what was necessary to stop it, and they clearly didn't, because it did happen. Imagine if Gordon Brown had taken measures to stop the housing bubble. The tories would have painted him as a rotten old meanie, stopping people from making free money by sitting on their arses. People like free money. There'd have been no need for a coalition with the Literally Dims. The US suffered a similar "negative correction" to the UK, so whatever Ron Paul did, it wasn't enough.

So, what's not entirely true?

Re:Economics... (0)

damburger (981828) | more than 2 years ago | (#37853026)

Don't worry, when peak oil bites, and we see a horrific Malthusian overshoot (that was only avoided previously by an injection of fossil fuel energy into the agricultural system) peoples lack of critical thinking won't be an issue. Nature will 'correct' us in the only way it knows how.

Re:Economics... (1)

ravenshrike (808508) | more than 2 years ago | (#37853060)

You've got at LEAST 100 years before peak oil hits. So keep dreaming.

Re:Economics... (1)

JasterBobaMereel (1102861) | more than 2 years ago | (#37853082)

First we would have to start drilling in difficult places where there was great danger in huge oil spills and we ... oh we have ...

Re:Economics... (1)

Arlet (29997) | more than 2 years ago | (#37853134)

Except that peak oil is hitting us right now, but don't let that you distract you. Production has basically been flat for the last couple of years, and most of the big fields are already in decline.

Re:Economics... (1)

flaming error (1041742) | more than 2 years ago | (#37853172)

"You've got at LEAST 100 years before peak oil hits"
How could I verify this? May I see your math?

Yeah right... (0)

Anonymous Coward | more than 2 years ago | (#37853164)

Just a clue, the "alternative ways to organize society" always fail when they scale up. Its like people claiming Sweden is a model, but then fail to note that Sweden is about 1/50th the size of the US in economy and even smaller in terms of population.

Or to put it another way... I am the head of my family. I provide food, shelter, education, money, cars, and whatever they want all in exchange for love & obedience (at least from the children).

And it works great, everybody gets what they want, when there is disagreement we work it out over dinner, and when I make a decision for the good of the family, everyone accepts that. I decided what religion we all follow, what personal habits they can have (smoking is not tolerated, not working is not tolerated, etc. with punishments meted out when they don't fit the established rules)

That doesn't scale very well.

Its the same for nations. A small nation with a homogeneous population can be governed much differently than a huge population with wide ranging opinions, backgrounds, beliefs, creeds, and temperaments.

Its why you can't compare China to any other nation. It why you can't compare the U.S. to Finland or Germany.

Re:Yeah right... (1)

blahplusplus (757119) | more than 2 years ago | (#37853180)

Societies have been organized differently in the past which is evidence that refutes your rather limited view of the world.

Re:Yeah right... (2)

jpapon (1877296) | more than 2 years ago | (#37853330)

Actually, I'd say Germany and the US are a pretty fair comparison. If you really believe the population of Germany is homogeneous, you should try visiting sometime.

I am not an economist (1)

Anonymous Coward | more than 2 years ago | (#37852934)

and I saw the current economic collapse coming.

Sometime back in 2006 (2005?) I read that the average american had spent more than they earned (i.e. borrowed on credit cards/etc.)

I then thought to myself: "self, start saving now because there is a storm coming."

Another indicator: housing prices were going up and up and up and all my friends were trying to convince me that buying a house is an investment (because that's what they were told) and that I should get a good one because I'd be able to turn it around for a profit. Since when is a house supposed to be an investment and not just a place to live in?

Re:I am not an economist (2)

varcher (156670) | more than 2 years ago | (#37852994)

Since when is a house supposed to be an investment and not just a place to live in?

But it is an investment.

What the housing bubble became wasn't investment. It was speculation. And every serious investor will tell you: never speculate with what you can't afford to lose.

Re:I am not an economist (1)

maxwell demon (590494) | more than 2 years ago | (#37853018)

It's an investment if you rent it to someone to live in, and expect to make your money (plus some) back from the rent. It's pure speculation if you buy in the hope of selling for more later.

Re:I am not an economist (1)

evilviper (135110) | more than 2 years ago | (#37853122)

Since when is a house supposed to be an investment and not just a place to live in?

It has always been that way. If houses weren't a good investment, practically nobody would buy one, because renting for 20 years is cheaper... You also wouldn't be able to get a loan at any rate, with anything less than absolutely perfect credit, if the banks didn't expect to be able to recoup the cost by selling the house if you default.

However, the idea of houses being a good investment is actually in jeopardy as never before. Across the developed world, population rates are stable, if not declining. With fewer people, demand for houses and property in general declines rather than the normal cycle of increasing demand. It's quite possible houses are no longer a good investment in developed countries, and you merely hope they won't depreciate in value too much, so you can recoup a good fraction of the money you've sunk in, and after years of not paying rent, you come out ahead.

Re:I am not an economist (1)

flaming error (1041742) | more than 2 years ago | (#37853212)

If houses weren't a good investment, practically nobody would buy one, because renting for 20 years is cheaper

If renting from a landlord is cheaper than buying it outright, how does the landlord make money?

Questionable math aside, I think you'll find most people actually do buy their house primarily for a place to live. Call us crazy, but some of us like to live under our own terms rather than a landlord's.

Opportunity (1)

Kupfernigk (1190345) | more than 2 years ago | (#37853260)

The landlord makes money either because (a) he inherited it and cannot find a better return on investment, or (b) the system is fixed to keep his interest artificially low, whereas the renter does not have the same access to cheap credit and so would have to pay more on a mortgage.

Re:I am not an economist (1)

jpapon (1877296) | more than 2 years ago | (#37853350)

If renting from a landlord is cheaper than buying it outright, how does the landlord make money?

Um, because at the end of the day, they can always sell the property? The tenant on the other hand has nothing at the end of the day. So even if the landlord's mortgage is more than he receives in rent... he is still making money...

Wow (4, Funny)

Hognoxious (631665) | more than 2 years ago | (#37852936)

So small changes in inputs can produce big, unpredictable changes in the output of complex systems? It's almost as if a butterfly flapping its wings could affect the weather!

They should find a snappy name for this marvelous discovery. Something like "chaos theory".

Re:Wow (2)

gorgonzola0000 (1416955) | more than 2 years ago | (#37852962)

I don't think this is necessarily due to differences in initial conditions. Even in the models were algebraic (i.e. not differential equations), having too many parameters and not enough data would lead to wildly erroneous predictions. You would be effectively fitting the model to noise. When the model does involve derivatives, it might be possible for the system to exhibit chaotic behavior, but that is not a necessity. It could be asymptotically or neutrally stable, but the prediction of the stable points could be wildly wrong due to erroneous parameter choices for the reasons I stated above. So, as one of the earlier posts indicated, the solution would be to simplify the model by decreasing the number of parameters and getting more data.

Re:Wow (0)

Anonymous Coward | more than 2 years ago | (#37853028)

it's not changes to the input.

it's that the model would come to wrong conclusion even on right inputs, because it models the behauvior wrong.

so the input in _creating_ that model was wrong and then the models were used wrong. because playing hot potato is fun but it needs bullshit religious reasoning to get people to go along with it longer.

Re:Wow (0)

Anonymous Coward | more than 2 years ago | (#37853058)

>> They should find a snappy name for this marvelous discovery. Something like "chaos theory".

Or "Economic Illiteracy Theory" where Obama displays his economics knowledge by sneezing, which results in people on Main Street falling over dead!

Re:Wow (2)

gnasher719 (869701) | more than 2 years ago | (#37853120)

So small changes in inputs can produce big, unpredictable changes in the output of complex systems? It's almost as if a butterfly flapping its wings could affect the weather!

Not what the article said. The article said: If a model can be parameterized, and there are so many possible parameters that the model can be made to match any past data by tweaking the parameters in many different ways, then you will end up with a model that doesn't predict the future.

In mathematics, if you have any set of n points yi = f (xi), then it is possible to find a polynomial of degree n-1 that fits these points exactly, and it is possible to find many polynomials of higher degrees fitting these points. If the data is just a constant with a bit of random noise, for example yi = 28.7 plus a random number between -0.01 and 0.01, then the actual data is very predictable (just predicting that it will be 28.7 is always very close to being correct). However, a polynomial trying to match the data will produce some enormous swings. The problem is with the model (data = high order polynomial) with a huge number of parameters, which didn't fit the reality.

Re:Wow (2)

Arlet (29997) | more than 2 years ago | (#37853222)

It's not what the article says, but it's not wrong either. Chaos plays a significant role in the real economic and financial world.

Subtle changes, such as whether Alan Greenspan put a comma before or after a word could make the difference between a good day and a bad day on the stock market.

Re:Wow (-1)

Anonymous Coward | more than 2 years ago | (#37853226)

Don't be a faggot. You're not funny.

Many people saw the economic collapse (5, Insightful)

mbkennel (97636) | more than 2 years ago | (#37852940)

Many, many, many people saw the economic collapse.

I was reading plenty of blogs on the housing bubble,, et etc, describing the preposterousness of "liar loans", subprime this, and idiocy that, and the crazy valuations.

The New York Times even had a plot of the inflation-adjusted Case-Schiller price index which was enormously above any prior peak. During 2006 and 2007 and 2008.

The notion that "nobody" saw it is simply propagandistic truthiness baloney. I personally didn't profit, because I was much too early shorting the mortgage companies & home builders and got stopped out---the bubble was too powerful.

The real crime is that a small number of very powerful people had an exceptionally lucrative interest in NOT stopping it, because they were getting ginormous paychecks from the continuation of the bubble. And now the notion that nobody could see it is used as excuses for the powerful to excuse themselves from responsibility from fraud and crime.

Down in the guts of banks, there were both risk modeling quants in the fancy banks, and the traditional "ladies with a bun" in the retail banks who processed the paperwork who saw how much outright fraud and insanity there was. Their jobs were threatened when they attempted to speak up and stop the madness, because the business side executives were making shitloads of shekels on volume.

Re:Many people saw the economic collapse (1)

mbkennel (97636) | more than 2 years ago | (#37852972)

Sorry for self-responding.

I read the original linked article.

"Carter had initially used arbitrary parameters in his perfect model to generate perfect data, but now, in order to assess his model in a realistic way, he threw those parameters out and used standard calibration techniques to match his perfect model to his perfect data. It was supposed to be a formality--he assumed, reasonably, that the process would simply produce the same parameters that had been used to produce the data in the first place. But it didn't. It turned out that there were many different sets of parameters that seemed to fit the historical data. And that made sense, he realized--given a mathematical expression with many terms and parameters in it, and thus many different ways to add up to the same single result, you'd expect there to be different ways to tweak the parameters so that they can produce similar sets of data over some limited time period."

Wow, you mean the maximum-likelihood plug-in estimator is NOT always a good representation of future variation? OMG! Hoocoodanode! []

Seriously, this should be known to everybody. For good results you don't estimate a single parameter vector, you estimate the posterior distribution and then resimulate outcomes from that distribution if you want to include estimation uncertainty.

No "chaos theory" involved, just a little bit of statistical experience known for decades.

Remember, there were many models whose job was NOT to make a truly honest prediction---the models were adjuncts to the sales force. They were there to make a simulacrum of an objective analysis but one whose outcome could be tweaked to give the profitable result needed by the salesman trying to offload the CDO full of turd.

Re:Many people saw the economic collapse (1)

ubergeek (91912) | more than 2 years ago | (#37853130)

Yeah, I don't understand why Scientific American considers this news. These are basic notions from machine learning and statistical modelling. It's not surprising, it's well established. If economists don't know this then they need to pick up a fucking textbook.

Re:Many people saw the economic collapse (1)

FhnuZoag (875558) | more than 2 years ago | (#37853204)

Yeah, this article is a pretty big duh for me. But well, guys, the whole field of statistics is built around finding proper ways to calibrate models. Economic models are maybe always wrong if you do things stupidly like these guys do, but there are alternative ways...

Re:Many people saw the economic collapse (1)

DerekLyons (302214) | more than 2 years ago | (#37853112)

The notion that "nobody" saw it is simply propagandistic truthiness baloney.

The real crime is that a small number of very powerful people had an exceptionally lucrative interest in NOT stopping it, because they were getting ginormous paychecks from the continuation of the bubble.

An enormous number of people had a lucrative interest in the bubble not stopping. (Even of you do accept the ludicrous notion that small number of people *could* have stopped it.) Real estate agents whose commissions were going through the roof. Mortgage brokers, ditto. Banks and credit unions who were taking their cuts of mortgages funneling through them. Home improvement stores that were doing land office business selling to builders, and to remodelers and DIYers (who were being paid from HELOCs as house values soared).
And it wasn't just the 'fat cats' either. It was Joe Sixpack who could (and did) sell his home for more than he bought it for five years ago, and who bought a new one at a lower interest rate to boot. It was Joe Sixpack employed by those profiting in the above paragraph. It was Joe Sixpack who watched the stocks in his retirement portfolio boom. It was the Jpe Sixpack stockholders and employees of the banks, real estate brokers, home improvement stores, etc... etc...
The notion that the only the 'fat cats' had a vested interested in not having the bubble pop is unmitigated bullshit.

Re:Many people saw the economic collapse (0)

Anonymous Coward | more than 2 years ago | (#37853182)

The real crime is that a small number of very powerful people had an exceptionally lucrative interest in NOT stopping it, because they were getting ginormous paychecks from the continuation of the bubble.

There's also a group of people outside the bank with significantly more collective power who could have stopped it, but instead chose to do things like take out loans to buy depreciating assets (cars, boats, appliances) and use the terms "credit card" and "income stream" interchangeably. I'm not saying that a lot of people at the top of a lot of the financial institutions aren't at fault (on the contrary, I agree that many if not most are), but there seem to be very few "average Joes" willing to take responsibility for a problem which their greed helped create.

Some economics professors saw it coming ... (4, Interesting)

drnb (2434720) | more than 2 years ago | (#37853276)

Many, many, many people saw the economic collapse.

A newsletter from an economics professor and CNBC financial commentator:
"Thursday, February 28, 2008 ... Any talking head who tells you that this market is a buying opportunity has his/her head screwed on backwards. The only buys are the kind of value plays that the likes of Buffett are pulling off. That is, it is very much a stock picker’s market. Recession plus inflation plus a credit crisis plus a softening European economy plus an inflation-plagued Chinese economy plus Russian strong-arming in natural gas plus two leading presidential candidates who are ignoramuses on economics plus a rising long bond in the face of Fed rate cuts does not a bull market make." []

That is his oldest newsletter but I understand he was telling his economics students to "get out" of the market in fall 2007. Plus he was showing them a whole bunch of historical indicators that were all pointing in the wrong direction.

Very few? (2, Interesting)

Anonymous Coward | more than 2 years ago | (#37852944)

Few people saw the collapse coming? Really?

All you had to do was turn on some form of broadcast radio after about 1995 and listen for a little while. When the commercial break appeared you heard one mortgage mill after another hawking refis, credit lines, etc. Bad credit? No credit? No problem! Interest only mortgage. Balloon mortgage. Jumbo mortgage!

This went on for years and years.

I saw it coming. If you missed it you're a fool. Maybe we just have a lot of fools.

Re:Very few? (1)

maxwell demon (590494) | more than 2 years ago | (#37853006)

Few people saw the collapse coming? Really?

All you had to do was turn on some form of broadcast radio after about 1995 and listen for a little while. When the commercial break appeared you heard one mortgage mill after another hawking refis, credit lines, etc. Bad credit? No credit? No problem! Interest only mortgage. Balloon mortgage. Jumbo mortgage!

This went on for years and years.

I saw it coming. If you missed it you're a fool. Maybe we just have a lot of fools.

I don't listen to broadcast radio with commercial breaks.

Re:Very few? (0)

Anonymous Coward | more than 2 years ago | (#37853160)

Hell, my economics professor spelled out the whole thing in detail a year before it happened.

As far as I can tell, the biggest reasons why he decided to be a professor were the ability to brag about his gains, and the incredibly fast university internet.

Models aren't equal to models (3, Interesting)

rmstar (114746) | more than 2 years ago | (#37852950)

Models aren't equal to models, and even rough models of chaotic phenomena can be very useful and predictive, if they are the right ones. Read this [] for some acknowledgement of which brand of economics has been right during the last few years. Here is another account [] , including some pointers to predictions of the current crisis reaching as far back as 1999. Krugman even has a "model" of how good models get out of fashion [] .

Economics suffers from the manipulation by political interests, and by the wish of many practitioners to project their moral ideals onto the world. Many economists simply go and try to prove that the world works however they want it to work, and find funding for that from rich supporters. That makes the endeavour biased.

Re:Models aren't equal to models (0)

Anonymous Coward | more than 2 years ago | (#37853038)

If you want a interesting paper, read this

If you knew what was coming... (1)

Kaenneth (82978) | more than 2 years ago | (#37852960)

The problem is, that once it's known what's going to happen, the arbitage people will make it happen sooner, and sooner, until it becomes faster to predict again.

It's like if next weeks lottery numbers were printed in a newpaper, everyone buys tickets with those same numbers, so that a $1 ticket wins a one two-millionth share of a million dollars...

I'm no expert (0)

msobkow (48369) | more than 2 years ago | (#37852968)

I got horrible marks in my University Economics classes. I grasp the basics, but not the various approaches that are espoused by the "experts" in the field.

But it's pretty intuitive to me that allowing the economy of the world to be impacted by the greed of a few is bad for everyone. Especially when those US economic interests are interfering with the policies, government, and economies of foreign nations.

I'll leave it at that, because otherwise I'll get slammed as an anti-American ranter instead of a proud Canadian who is affected by US policy, but unable to impact it.

Economic models are fundamentally wrong anyway (1)

Isembard_KB (1222826) | more than 2 years ago | (#37852976)

The basic theories of economics slavishly followed by bankers and governments that rule all our lives are based on patently wrong assumptions and simplifications, compounded by bad maths. Professor Steve Keen's book 'Debunking Economics' explains all. You don't know whether to laugh or cry when the stupidities are revealed one by one as the book progresses. We need a major change to the system to escape from it. (Debunking Economics - The Naked Emperor Dethroned, Steve Keen, Zed books Ltd)

Re:Economic models are fundamentally wrong anyway (0)

Anonymous Coward | more than 2 years ago | (#37853050)

Jesus. Not your fault, really, that I responded to your comment specifically, but i can't stand any more. Straw and the camel's back, all that.

Can you all please pull your heads from your nether regions? It isn't wrong assumptions, or bad maths, which has caused the economic situation we're in... these people you say have got it all wrong have got it totally right. They've made trillions from what you call stupidities.

Quit assuming that what's bad for you is bad for the people who run the system; it just ain't so. Most of civilized human history is a story of a few haves screwing the bejeezus out of the have-nots and living beautiful lives while everybody else suffers. It's a modern conceit that it no longer works this way. Guess again, people; you're living it.

You want it to get better? Start with admitting to yourselves that those who are in charge (yes, those wonderful people you voted for because they said all the things you love to hear, and my god, they just must really mean it) are only there to further the interests of themselves and those like them. Yes, they're causing you pain. They don't care. Their lives are awesome.

Want it to change? Quit voting for people because they're willing to be more loudly obnoxious than the next guy. That'd be a really good start.

Real world (1)

symes (835608) | more than 2 years ago | (#37852990)

I recall an article in the Econonist a few years back that described a time when a macro economist visited his chum, who worked on a trading desk in a large bank. The economnist basically came away saying that there's simply no time or space for elegant theories in anything that went on in that environment. The science of economics was more applicable to fly fishng than high frequency trading. But I think the real issue for economics is that it has historically been very prescriptive - what people should do - rather than descriptive - explaining what people actually do. This was forcefully highlighted by the psychologist Kahneman, who went on to win the nobel prize for economics. That said, I enjoy economics and do feel it offers a lot to the world. I also think the premise that economic theory didn't predict the economic collapse is wrong. My limited reading of economic theory left me with the impression something was going wrong (in particular Shleifer, A (2000). Inefficient Markets: An Introduction to Behavioral Finance). But any prediction using economic theory presumes we have access to the evidence required to make accurate predictions. What we are slowly seeing is that, in their rush for profit, institutions effectively hid their exposure to risk. This duplicity, more than anything, compounded by a healthy dose of herd behaviour, is the reason the approaching precipice was obscured.

Re:Real world (0)

Anonymous Coward | more than 2 years ago | (#37853294)

" in their rush for profit, institutions effectively hid their exposure to risk"

Yes, but that was the fault of Wall Street to a great extent.

Wall Street analysts were vocally critical of any financial institution which wasn't heavily 'growth' centric. That negative criticism had a bad impact on the stock price, and caused a lot of angst (both internally at the banks, and amongst the stockholders).

This led the banks to focus almost entirely on sales, and sales at any cost. The bankers figured that they could off-load the mortgages to Fanny and Freddie and make their cut on the fees. The more mortgages, the more fees, and the more growth. Wall Street would be happy, the stock price would increase and life would be good.

Unfortunately, the increase in the number of people falling behind on their mortgages caused Fanny and Freddy to stop buying the mortgages, and the banks got stuck with them.

It was remarkable (being one of those who was on the inside of all of this) that the 'sales' based decision made by one or two people at the top led to the catastrophic failure of banks who should have been totally risk-averse to begin with.

Adjusting gravitational constant (3, Funny)

maxwell demon (590494) | more than 2 years ago | (#37853002)

From the article:

"If you had to readjust the constant in Newton's law of gravity every time you got out of bed in the morning in order for it to agree with your scale, it wouldn't be much of a law But in finance they just keep on recalibrating and pretending that the models work."

Wait ... you are saying the growing number on my bath scale isn't because the constant of gravity is growing? :-)

The problem is much simpler (0)

Anonymous Coward | more than 2 years ago | (#37853016)

The reason for the failure of models is much simpler: economics is not physics!
If you find the perfect model and the perfect set of parameters today and use it, you change reality - thus markets will see that you're making loads of money, react and anticipate your knowledge, which renders it useless so that you'll need a new model that takes your old model plus the new reality into consideration.

However, finance and economics are still useful as they help to understand reality better and improve allocation of ressources and information, although we did not achieve perfect markets yet. If we would want a constantly growing global economy without volatility, we would need perfect information flow so that every agent in the market can anticipate the future. Anyway - until we can predict every earthquake, every storm and even the day of death of every single goat perfectly, we'll have financial volatility - so we gotta learn how to deal with it.

Now how to deal with the fact that our world is dynamic?
We need insurances. The current financial crisis, for instance, hit people who lost their jobs and don't have an unemployment insurance much worse than capital owners who lost a far higher share of their fortunes. For instance, if you had 10 millions in 2007 and now have 2 millions, you probably won't have to change your lifestyle as much as a father of a family who had 10000 dollars on his bank account and now has 8000 but lost his job and can't find a new one.

The perfect solution, however, would be to make labour markets more efficient: companies should be able to reduce worker's salaries easily and workers should be able to buy an insurance against having their salaries reduced. Thus, we shouldn't try to change financial markets, as we can't - we should improve labour market to reduce suffering.

From a more practical point of view, this is how we (an egineering company) dealt with the financial crisis:
When we didn't get new contracts anymore due to investment stops all around the world, we just finished our ongoing projects a little slower and asked our staff to finally take their well-deserved holidays in their holiday accounts, which they accumulated over several years because we've been really busy and workers had to work extra hours as we couldn't find enough qualified engineers.
Now as the crisis is easing, we got the same efficient team we've had before, but have everything in our office tided up and a far more relaxed atmoshpere because our workers finally could do what they never had time for before. So although we certainly didn't benefit from the crisis financially, we benefited hugely in terms of living quality. And of course, when engineers are bored, they start inventing stuff - so we can now offer much better products than before the crisis, which will also pay off ;)

Re:The problem is much simpler (1)

jcr (53032) | more than 2 years ago | (#37853166)

economics is not physics!

That is the great insight that Ludwig Von Mises repeated throughout his career. Attempting to model human behavior as if it were possible to predict our behavior the way you can predict the outcome of elastic collisions is preposterous. There are however, economic laws which can't be overcome by violence or wishful thinking, and it was the operation of those laws that made the collapse of the romans and the soviets (to name two obvious examples), inevitable.


Finance does not equal economics (0)

Anonymous Coward | more than 2 years ago | (#37853020)

Sigh, misleading thread name which makes basic error of confusing finance with economics. This may be news to some people but they are not the same - you only have to talk to a Financial Quant Analysts for around ten seconds before this becomes immediately apparent (they are basically statisticians)

Anyhow on the main points:

1) Lots of economists were pointing out the increased risks in the global economy prior to the financial crash, they were ignored all called 'doomsayers'. In part because it was in the interest of vested interests to do so, but also because it is now clear that actually some of those interests (e.g. the Banks) really didn't know what they were doing.

2) Nobody predicted exactly when it was going to happen because you can't predict the kind of confluence of several events which trigger that kind of crisis. Contrary to what some financial experts were saying this was not a one in a million event, as ultimately they lost sight of the difference between systematic and non-systematic risk.

3) In part this is because economics handles confidence effects poorly, a lot of models try to pin things down to fundamentals on the assumption that eventually they will act as an 'attractor' and drag the econony back on track.

4) Economics also handles financial markets poorly, partly because of the confidence issue (above) but also because of how wealth and confidence effects effect behaviour in asset markets.

e.g. you buy a house, if everyone buys houses their value starts going up due to scarcity, this makes homeowners more wealthy on paper, so they upgrade to a bigger house or spend their wealth on other things, add in speculation in the housing market and you can see how this cycle can go on and on. But, confidence effects can inflate this well beyond fundamental values which means if something serves to kock that confidence (say a recession) it can go into reverse. So this combination of factors acts like an amplifier in either direction, which is obviously not good for market stabilty, particularly when factors like confidence can shift very rapidly.

The main problem with most commentary on economics is that it comes from pundits or half experts who have an interest in taking a position one way or another (typcially working back from the conclusion they want and choosing their model to get there).

Systematic problems (1)

Internetuser1248 (1787630) | more than 2 years ago | (#37853024)

the article suggests that our financial woes are caused by miscalibration of bank and stockmarket software models. I submit that the system itself is flawed. You can't make a working model of a broken system. The idea that if we could find a better software solution for banks all our financial problems would end is absurd.

Re:Systematic problems (0)

Anonymous Coward | more than 2 years ago | (#37853190)

The whole idea that the economy is only good when it grows is a very apparent basic flaw.
We cannot earn more than before every year.
Sure it can happen for a few years, but this is not a sustainable situation.
A collapse is inevitable.

Wow (1)

yacc143 (975862) | more than 2 years ago | (#37853030)

So now stuff done in an introduction to numerics class is news.

Not much known to the general population, there are problems that cannot be calculated numerically, usually because a change of input magnifies immensely on the output. So an error of 1 on input becomes an error of 10^n (with n in the two digit range and bigger). The issue here is that basically by definition all numerical systems used to calculate in a computer have builtin error sources, and errors do accumulate.

The pain becomes even bigger if you consider that in floating point numerics basic mathematical laws do not apply, e.g. (a + b) + c = a + (b + c) is true in mathematical sense, but is in general untrue for floats. Using fixed point arithmetics, while in theory better, implies a rigorous error analysis (floating point is kind the "automatic" solution to the required analysis for fixed point arithmetics), which is especially in such "fantasy" models hard to do. (For many coefficients the "designer" of the model has no idea what the range of valid values might be. If you do not know the value range, you basically are forced to floating point, implicitly accepting that you have no real idea about the error to be expected, beyond the general knowledge of the used floating point system.)

There is another MUCH simpler reason (0)

Anonymous Coward | more than 2 years ago | (#37853036)

1) economic model are used to represent a steady state and can't represent well, or even AT ALL, rare outliers event.

2) they are worth shit anyway as the "perpetual growth" model can only fail. You can't have perpetual growth with finite resources.

Lots of math with no science is very bad (1)

bigsexyjoe (581721) | more than 2 years ago | (#37853040)

of Economics tries to take the veneer of science by using a lot of mathematics. But this is not good. With powerful enough mathematics you can make almost any story you please fit your historical data. And there is certainly plenty of motive to do just that. Economics is rarely based on experiment. Granted there might be some psychological experiments that can inform economics, but most economics isn't based on that.

Re:Lots of math with no science is very bad (2)

jcr (53032) | more than 2 years ago | (#37853176)

Economics tries to take the veneer of science by using a lot of mathematics.

Just like Astrology.


Nothing to do with chaos theory (1)

Saunalainen (627977) | more than 2 years ago | (#37853056)

The phenomenon this guy has observed is nothing to do with chaos theory, as several posters think, but rather to do with error propagation and model uncertainty. This is an issue whether the model is chaotic or not. His mistake is to think that calibration has to choose a single set of parameters, and then one has to make a single prediction from the model. Statistical methods can take into account many sources of uncertainty, including the range of parameters that could have produced the original data and intrinsic stochasticity in the model. The best way to do this is using Bayesian techniques.

You're still limited by how realistic your model is, and this is likely to be the real problem with economic models. However, Carter's argument (that it's fundamentally impossible to fit a model to itself and then make consistent predictions) is wrong.

Balderdash (2)

ravenshrike (808508) | more than 2 years ago | (#37853080)

"Or how very few even saw the current economic collapse"

Y'know, there's an entire school of economics that predicted the collapse. And the collapse before it and the ones before that. It's called the Austrian school. But even though they predicted every single damned collapse because they didn't use shiny models and after the mid 90's shiny powerpoints nobody pays any attention to them.

Keynesian vs Austrian Economics (0)

Anonymous Coward | more than 2 years ago | (#37853088)

It's not that the model's are wrong, it's that they're based on a theory that has proven time and time again that it doesn't work. Have a read of these two articles and guess which one we're currently using.

And now try to guess which has correctly predicted ALL of the previous economic disasters (and the even larger one looming next year).

The failure of the former model comes from trying to mathematically model human actions themselves which are inherently unpredictable.

Re:Keynesian vs Austrian Economics (1)

jcr (53032) | more than 2 years ago | (#37853188)

the even larger one looming next year

The Austrian school doesn't presume to say when these collapses will happen, only that they must. It's like watching termites attacking a house. You know it's going to fall eventually, but whether it takes a year or five years depends on far too many factors to predict.


There are probably lots of good models... (1)

Pence128 (1389345) | more than 2 years ago | (#37853092)

But people don't want good models. They want models that predict massive proffits. Doubly so when they're paid on commision and it's someone else's money.

All models are wrong (4, Interesting)

Bud (1705) | more than 2 years ago | (#37853114)

"Remember that all models are wrong; the practical question is how wrong do they have to be to not be useful." (George E.P. Box and Norman R. Draper, Empirical Model-Building and Response Surfaces (1987), p. 74)

"One of the most insidious and nefarious properties of scientific models is their tendency to take over, and sometimes supplant, reality." (Erwin Chargaff)

I think that says it all, really.


Which economic system? (1)

NetShadow (132017) | more than 2 years ago | (#37853140)

The Keynesian system of economics fails to model reality well because it's seriously flawed. The Austrian school of economics, which is similar to what was used in the United States pre-Keynes and whose economists did accurately predict the current economic crisis, is an entirely different matter. Look at Peter Schiff, Ron Paul, and a number of others -- they have been debunking Keynes for years. They've also been pointing out that the artificial "stimuation" of spending and the idea that your house is an investment rather than a liability or at best an item whose value is controlled by supply and demand and with the retirement of the baby boomers was bound to experience a slump in demand. With the addition of government interference in backing unrealistic loans for those who couldn't afford them, the writing was on the wall. We need to ditch the idea of a "centrally planned" economy and Keynesian economics generally if we want to have any kind of realistic understanding of how markets really work, and before we shoot ourselves in the foot yet again.

sh17? (-1)

Anonymous Coward | more than 2 years ago | (#37853146)

Clutching at straws again? (1)

Grindalf (1089511) | more than 2 years ago | (#37853174)

They didn't use economic science! No way is this stuff due to any real economists input.

Good god... (1)

Totenglocke (1291680) | more than 2 years ago | (#37853196)

That man knows nothing about economic modeling. His whole story about "calibrating the model" is just pure and utter bullshit - so much it makes my head hurt to read that. Sure, someone trying to model who knows nothing about it might try to force the model to fit the data, but that's not how actual Economists do it - you'd get laughed out of grad school if you tried the things he mentioned in his articles in a research paper. I'm currently finishing up my Masters in Applied Economics and do quite a bit of modeling on a regular basis. There is no "calibration" - merely statistics. You include all the variables you consider relevant and then start whittling out the ones that are statistically insignificant in explaining the variation in your dependent variable. When dealing with forecasting, you never use the full time series data set in your model - you use most of it and then leave part of it for testing the accuracy of your model (so you can compare the forecast values with the actual values). If you've done a good job collecting a large enough data set and including the necessary variables, you'll have some pretty damn good predictions for the first part of your time series. Obviously, like with any type of prediction, the farther into the future you try to forecast, the less accurate you'll be. Hence why you continually gather more data and further refine your model and keep redoing the predictions.

The other wonderfully fallacious thing that he had in his article was not pointing out that Finance is NOT Economics. Financial data, such as the stock market, is VERY hard to predict (and actually due to basic financial theory regarding market efficiency, if the market is efficient then you should NOT be able to predict stock prices) due to the obscene amount of variables involved and the fact that there are decisions made based off emotion and not purely mathematical logic (such as bank runs and panics in the stock market).

It is much simpler... (1)

bankman (136859) | more than 2 years ago | (#37853214)

...and Peter Drucker observed or rather stated the obvious years ago: One can't really compare models in physics with models in economics, though it's tempting. The problem is, the model or a theory that tries to explain the real world beaviour will be applied in the real world which will in turn influence the real world system, which will eventually adapt, rendering the initial observations (that led to the theory in the first place) irrelevant for future explanations. For example: Every theroy we build on which parameters influence inflation will eventually influence economic behaviour by tuning monetary and fiscal policies according to theory. Market participants will eventually accomodate and alter their inflation expectations and in turn economic activity. Compare that to a model in physics: No matter what the explanation we find for the real world system, that theory will not influence the system. It doesn't matter to the system whether we think Newtonian physics or relativity is correct.

So, every economic model or theory will eventually become wrong. Econophysics, statistical mechanics and complex network theory may be the key to unlocking economic science and taking it a step further (from crystal ball gazing)....let me dream....

It's obvious and infront of us.. (0)

Anonymous Coward | more than 2 years ago | (#37853240)

All money is debt; money is created from debt. It is created out of thin air when a loan or credit is taken. It does not exist outright in the money supply until the debtor makes payments plus interest to the creditor. Furthermore, it is impossible to repay all debts in existence because the money for the interest payments does not exist in circulation. Economists throw more debt at debt expecting it to make a difference, when all we get is the inflation and we pay for it with higher prices and our savings lose value. Where is the sense here?

It is only a matter of time before our monetary systems collapse entirely. I believe we are seeing this right now. Let's apply science to our social systems and implement a resource based economy for the good of all mankind! See The Venus Project, I think you slashdotters will love the concept.

This is common knowledge. (1)

mosb1000 (710161) | more than 2 years ago | (#37853244)

I work with groundwater models, and (at least where I work) we do not consider the models to be predictive. Rather we hope they will give us a better idea of what is happing with a particular site. We combine this with "trend" analysis and real world data to get an idea of what's actually going on with a site. We do not believe we know what's going to happen based on the model, but we hope that the model will tell us what direction things are headed so we can prepare for it.

Working backwards from desired conclusion (0)

Anonymous Coward | more than 2 years ago | (#37853324)

i) ?????
ii) ????
iii) Free market solves all known problems
iv) Profit

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