The idea that people hold “mental models” of the world may seem trivial or obvious, or both.  Everyone has a way of seeing the world, affected by the cultures and the families in which we were raised, our own experiences, our personalities, and so on.  Mostly, they account for our individual differences; why some of us are conservative and others liberal; some more optimistic and others pessimistic; some risk-taking and others more reserved and cautious.

Some of those models are much larger, and more pervasive, than others, though.  They guide decisions that affect what is taught at universities, how businesses are run, governmental policies, etc.  Science and religion both have views of “how the world is” – the nature of reality and how things work (or should work.)  The US Declaration of Independence, and the Constitution, reflect beliefs about human nature, governance, and how we should relate to each other.  Formal, mathematical models of all kinds purport to describe and predict phenomena.

The most critical models are probably those that remain invisible to us – those that we never think to question, or may not even recognize that we hold.  The current world-wide financial crisis – now apparently an official recession – has brought many of those models into view, and into question.  In recent testimony before the House Oversight Committee, Alan Greenspan explained that “he had made a ‘mistake’ in believing that banks in operating in their self-interest would be sufficient to protect the their shareholders and the equity in their institutions.  Greenspan called this ‘a flaw in the model that I perceived is the critical functioning structure that defines how the world works.'”

This is a profound insight and admission from the person who directly affected world financial markets for 18 years, and until recently was considered to be incredibly successful in his approach.

The point here is not to denigrate Alan Greenspan.  It is to point out the nature and importance of our models of the world.

The reason for using Mr. Greenspan’s example is primarily to contrast the models involved – the many formal economic models employed by economists, based on gigabytes of data, and the mental models that lay behind them.

Every model involves a selection of data, of what is considered to be pertinent to the issue at hand.  It is a description of something thought to exist, and how it works – what matters, what makes a difference.  It is based, then, on a set of beliefs about the “something” that comes prior to the model.

In the case of Mr. Greenspan, he was rather famous for being secretive, or at least less than transparent, about his personal model of the economic system.  As explained in a January 27, 1997 Wall street Journal article (Fed Chief Sets Monetary Policy By Seat-of-the-Pants Approach):

“Mr. Greenspan relies not on computerized econometric models, but on old-fashioned judgment. He doesn’t invoke economists’ sophisticated rules of thumb, such as a link between low unemployment and future inflation, but instead watches gauges, such as how fast suppliers fill orders from factories, that usually signal a buildup of inflationary pressures.

“In making the forecasts essential to setting monetary policy, he views the data through a lens of his own design, one that changes with circumstances. Essentially, he searches for the one significant factor that distinguishes the current business cycle from previous ones. Once he finds it, he looks at all the data with it in mind.”

The current financial crisis will not be solved by finding the right person or persons to blame.  There were certainly mistakes made, and actions by individuals that we do not want to encourage or repeat.  But the critical question for the moment is, if the world (especially the economic world) does not work the way that Alan Greenspan believed, how does it actually work?  What should we affect in order to re-correct the system?

An article in the October 27 issue of BusinessWeek magazine (Engardio, p. 22) questions fundamental economic principles:

“The Bush Administration, by committing $250 billion to buy equity stakes in a huge swath of the U.S. banking system and extending all manner of financial guarantees to depositors and money-market investors, has just violated some enshrined principles of American-style, free-market capitalism… The significance, not to mention irony, of a Republican Administration partially nationalizing the U.S. banking system cannot be overstated.  It could well go down as an important turning point in postwar American economic history, the beginning of a fundamental rethink of the proper boundaries between the public and private sectors.”

In the end, what makes the economic system work is whatever gives us the confidence to continue interacting and engaging in exchange with each other. The importance of the model that we use is what it tells us about what is important.  If the economic system is a self-organizing entity (like a living organism) and is fundamentally guided by an “invisible hand” then attempting to fully regulate it would be like trying to make a living robot, i.e. making a mechanical version of something that was fundamentally not mechanical. If it is something different, then we must understand it differently.

Alan Greenspan’s revelation questions the nature of economic systems at their foundation, all the way back to Adam Smith.  If individual entities working towards their own self-interest is not the key to the success of the economy, then what is?   If external regulation is important, then of what kind?  Do we understand it best by analogy, like the circulatory system needing the respiratory system, or do we understand it “as it is” – as a unique entity comprised of its own elements and interactions?

The debates occurring in financial and political centers around the world are mostly based on long-standing assumptions.  For some, economic fundamental remain intact and markets are only self-correcting (though pretty dramatically.)  For others, the present turmoil is an indication that unfettered capitalism is not sustainable.  The coming days and weeks will likely evidence a series of responses to trial-and-error remedies based on the models that are held.  With luck, something will work.

Questioning models at a deeper level is not something that we seem to do well.  As Americans, especially, we seem to assume that pragmatic trial-and-error is more efficient than philosophical reflection.  Rebuilding models on which we can rely, though, will require studied consideration, and matching the models to the actuality of the system will be critical if we are going to make effective corrections.