A Review of Models, Behaving, Badly.
By Justin Shaw
Sophomore Marketing and Business Administration Major
The word economist conjures to mind one of two things: either the image of a Wall Street financial advisor confidently plugging numbers into a formula, or a philosophical economist lecturing on why economics is not a science. Emanuel Derman addresses both of these stereotypes in his book Models. Behaving. Badly. Derman takes a middling approach to the age-old question of how to deal with mathematical models in economics.
The author does an excellent job inserting relevant memoirs that guide the reader to the same conclusions Derman arrived at himself. The book is divided into three sections, and the first consists of anecdotes from Derman that demonstrate the fallibility of models when dealing with humans. First, Derman discusses failed political models in the form of Apartheid and the socialist movement he experienced as part of growing up in South Africa. He follows up this section by addressing the issues of how models and theories are developed and used in sciences. Derman's background as a physicist gives him a unique perspective which he conveys to the reader in small, digestible chunks of physics lessons. These lessons culminate in the message that finance is different than arithmetic or physics because physics uses abstracts that do not directly relate to the real world. He uses the concept of an abstract triangle, which does not exist, but we base formulas off of; this is in contrast to economics since economic formulas try to relate abstracts to reality.
Finally, the author discusses economics exclusively and calls for the end of our misuse of economic models and theory. While models and formulas have their place, Derman argues, we rely far too heavily on them, which he claims contributed to the financial collapse in 2007. People can make their own decisions concerning value; however, investors rely heavily on magic formulas that supposedly reflected the general trend of the market. The issue that Models. Behaving. Badly. Tries to address is that people give economic models, theories, and hypothesis far too much scientific credibility. Darmen proves his point by deconstructing a common economic hypothesis. The Efficient Market Hypothesis claims that things will always reflect their current value based on the information available. Darmen disputes that this hypothesis is fundamentally wrong because humans assign value. Humans are not perfect, and they often make mistakes. Something as mercurial as value is the basis of a commonly accepted hypothesis, but history proves that humans can, and will, be horribly wrong about the true value of things, demonstrated by literally every market crash in US history.
The book Models. Behaving. Badly. is a work for laymen. Derman takes the time to explain anything that might be cause for confusion, from electromagnetic theories to stock market vocabulary. The book itself details Derman’s view on why economists should avoid heavy reliance on models and theories, especially when the foundation of those theories and the inability to test them in a controlled environment make them impossible to consider empirical. Whether you agree or disagree with Derman’s points, the book is still an enjoyable read. The hardcore economist might want to pass on this book if they are purely interested in theory or statistics, but for someone new to the world of finance, it is well worth the read. The only quibble I had with Models. Behaving. Badly. was the number of anecdotes Derman decided to include. While the stories are relatable in some way to what Derman was trying to say, it brought to mind the saying, “Not seeing the forest for the trees.” The historical tales and personal memoirs all tied into economics eventually, but if I were to have skipped straight to his financial opinions in the last third of the book, I would not have lost as much as I should have.
Despite its failings, Derman’s work teaches a valuable lesson. The book begs the question of how models affect economic freedom. Derman sums up my takeaway in one sentence on page 200, saying “People continue to act out their destiny mechanically, doing what they unthinkingly believe they have to do.” Because of the perceived credibility of models, people are willingly restricting their economic freedom. Models themselves do not inherently limit choice; however, by looking at models as the magic bullet for any problem, economists deceive themselves and others by claiming they know the answer based on formulas or models.
In short, Models. Behaving. Badly. is an excellent explanation for why current models and theories are overused and lack a strong foundation compared to hard sciences like physics or quantum mechanics. Models and theories have their place, but overeager investors often rely too heavily on them. Derman’s personal and historical anecdotes, while interesting, would often bog down rather than support his theories. Despite that issue, the book is still an enlightening read for the beginning economist.