Are Economic Models Leading Us Astray? Unmasking the "Chameleons" of Finance

'Chameleon' models in economics and finance refer to theoretical models that rely on simplifying assumptions that have dubious connections to reality. These models change colors to avoid scrutiny of their underlying assumptions. When their conclusions are applied uncritically, they can muddy policy debates and devalue intellectual currency. The issue arises when models, built on assumptions with weak links to the real world, are used to inform important decisions without proper evaluation.

'Theoretical cherry-picking' involves selecting assumptions specifically to produce a desired outcome, essentially reverse-engineering a model to support a pre-determined conclusion. This is a problem because the resulting model may not accurately reflect the real world, even if it produces seemingly compelling results. The limitations and potential biases introduced by this process can undermine the validity and applicability of the model. While reverse engineering can be a useful tool to explore the assumptions required to get a given result, it can cause problems when those assumptions are not grounded in reality.

Tractability, the ease with which a model can be analyzed and understood, is often considered a virtue in economic models. However, defending assumptions solely on the basis that they make a model 'tractable' can be misleading. While simplicity is valuable, it shouldn't come at the expense of realism and relevance. Overly simplified models may fail to capture the complexities of the real world, leading to flawed conclusions and misguided policies. There is a tension between tractability and realism that can be hard to balance, but it is important not to sacrifice the latter for the former.

While economic models cannot include every factor, the exclusion of important elements can significantly skew the results. Modelers must carefully consider what to include and exclude, and justify those choices. The omission of key variables or relationships can lead to an incomplete and potentially misleading picture of the economy. The excluded factors may have an effect that is important to the result of the model, and in some cases they may even reverse the results.

To avoid the pitfalls of 'chameleon' models, it's essential to subject them to rigorous real-world filters. This involves carefully examining the assumptions, considering their connections to reality, and assessing whether the model captures the most important factors at play. Critical evaluation and grounding models in real-world knowledge are crucial for moving towards sounder economic reasoning and more effective policies. Ignoring the assumptions that go into a model opens it up to being a 'chameleon' model.