Making Economic Models

All economic models are based a few fundamental Axioms. Axioms are statements that the public accepts as true. For Keynesian or conventional economic theory the Axioms come from Supply and Demand principles. N. Gregory Mankiw in his book, Principles of Economics, defines the Law of Supply and Demand as "the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance." N Theory, on the other hand, states the price of goods are established in a negotiation between Buyers and Sellers. Since the negotiation is between many individual Buyers and Sellers there are many prices for the same goods.

This break from conventional economic Axioms is what distinguishes N Theory from most economic schools. With a different economic foundation N Theory follows a different path in the way economic models are structured.  Unlike most economic models based on supply and demand mathematical relationships, N Theory takes a different approach. It looks at the way economic actors interact and tries to improve those interactions based on a set of principles or economic rules. This is the approach a mechanic would take to fix your car. He would look at how all the parts are supposed to interact and look for variances.

If your car doesn't start you could create a model that describes all the steps necessary to obtain ignition or you could look at likely causes due to operator error or inattention to necessary maintenance (lack of gas, clogged fuel line, dead battery). Conventional economics takes the first path and N Theory follows the second. The problem with taking the first path is that unless the car was built and maintained flawlessly there is a possibility of an unknown circumstance, a black swan (a circumstance not considered in the model) occurring that prevents ignition. Since the circumstance is not in the model it will never be discovered by running the model. Testing a model involves varying the inputs or increasing the precision of the data. An economist can spend a lot of time scratching his head and repeatedly running his model, but with a black swan in the car never find the problem.

N Theory, on the other hand, states there are two possibilities. Either the problem is in the car or with the driver. Analyzing both the car and driver covers all the factors affecting performance unlike the approach taken by conventional economists where the search is focused on the functioning of the vehicle. By looking at all the economic actors new problems can reveal themselves and make uncovering the black swan much easier.

The difference between N Theory and conventional economics is that N Theory looks at the economic system for flaws and conventional economics looks at the model or model outcomes for flaws. N Theory looks at how the system "works" and conventional economics looks at how the system "changes" with new inputs. Conventional economics cannot analyze how these new inputs affect the human perception of the "working" of the system. Through surveys and tests N theory can get a sense of the human or user response, but conventional economics depends on a solely mechanical or mathematical response by users.

Why waste time with a model? Conventional economics assumes you cannot determine whether the economic system is subject to failure or performance blips by looking under the hood or bonnet. Fortunately that is not the case there are numerous indications of potential failure. Fluid leaking out of the engine compartment is always a concern, a sudden change in the sound of the engine or a clicking sound from the starter are all indications that a mechanic should be consulted.

The Housing Crisis was missed, because the hood or bonnet was not opened. The signs of engine wear were obvious. These signs were not uncovered, because the mechanic was bent over his computer trying to predict an engine failure. He had all the evidence behind him in the garage.

Using an N Theory perspective it is quite clear the real villain in the Global Financial Crisis was the economic modelers. The credit agencies and the risk departments at the large banks failed their clients. They did not look at the products for performance in the real world and failed to evaluate how investors would respond to cracks developing in the master cylinder. It was not greed, but a total reliance on incomplete models that caused the crisis.