The Financial Crisis and How We Understand How Things Work

on Mar 3, 2010

The 2008 financial crisis was especially rough because it was so unexpected. This fact raises a couple of interesting points. One is that those within the industry that understood what was really going on were keeping mum as it was in their interest to do so. The other is that so many of our economics experts and whatnot didn’t see this coming. This latter point tells us a lot about how we understand how stuff works.

There are two approaches to understand how any part of the world works. The initial and more accessible manner is to discern patterns from observations without necessarily having an understanding of the underlying mechanisms. This was pretty much the only way humans made sense of the world for most of history. This top-down approach is quick and dirty – immediately useful – and a required process to eventually, if ever, build another method of understanding how something works.

The bottom-up approach is to understand basic mechanisms and build more complex mechanisms from more simpler ones. This approach is very powerful because it works on a system of rules which allows us to make testable predictions. Empirical data, instead of coloring the model, determines whether or not the rules (and their predictions) are valid. This is actually another way of expressing the scientific process.

So a top-down understanding of the workings of a car could mean that you understand that the pedals and steering control the motion of the vehicle and that it requires gasoline to run. This is sufficient knowledge to operate the vehicle. But this doesn’t help you if you’re car begins to malfunction. A bottom-up understanding of machinery inside a car would aid greatly in this case. However, for the sake of efficiency, most of us put trust in specialists that understand cars (auto mechanics) so that we don’t need this knowledge ourselves. Which is fine for this circumstance.

How does this work for understanding something complicated than a car, like the economic system? Surely we have specialists (the “experts” I mentioned in the first paragraph) but what is their approach? For most economists (if not all) it is top-down. They build models from empirical data (and they really do an incredible job of gathering this data). Their models are probably generally accurate but not all the time. The financial meltdown is a very clear, and costly, example of when it is not. So what happened? Well, because top-down understanding is built from empirical data, it possesses the danger of being colored by the data. Over time, the model is tweaked to fit new information, which can bring about even greater surprise if it’s wrong.

So what would be a bottom-up understanding of economics? It’s most certainly difficult to approach it this way; it’s doable though. Since economics is really just social exchange between humans, we can determine a good theory of it if we understand human social behavior. I’ll be sure to discuss this in a future post.

As for our approaches in understanding how things work: each method has its strengths and weaknesses. We should use the top-down approach whenever it is sufficient, as it is very sleek. But we should be mindful of when its disadvantages may spell trouble. Otherwise, a bottom-up approach, if available, proves to be essential.