Uncertainty and reflexivity — two things missing from Krugman’s economics

18 Sep, 2014 at 09:36 | Posted in Theory of Science & Methodology | 7 Comments

One thing that’s missing from Krugman’s treatment of useful economics is the explicit recognition of what Keynes and before him Frank Knight, emphasized: the persistent presence of enormous uncertainty in the economy. Most people most of the time don’t just face quantifiable risks, to be tamed by statistics and probabilistic reasoning. We have to take decisions in the prospect of events–big and small–we can’t predict even with probabilities.uncertainty Keynes famously argued that classical economics had no role for money just because it didn’t allow for uncertainty. Knight similarly noted that it made no room for the entrepreneur owing to the same reason. That to this day standard economic theory continues to rules out money and excludes entrepreneurs may strike the noneconomist as odd to say the least. But there it is. Why is uncertainty so important? Because the more of it there is in the economy the less scope for successful maximizing and the more unstable are the equilibria the economy exhibits, if it exhibits any at all. Uncertainty is just what the New Classical neglected when they endorsed the efficient market hypothesis and the Black-Scholes formulae for pumping returns out of well-behaved risks.

If uncertainty is an ever present, pervasive feature of the economy, then we can be confident, along with Krugman, that New Classical models wont be useful over the long haul. Even if people are perfectly rational too many uncertain, “exogenous” events will divert each new equilibrium path before it can even get started.

There is a second feature of the economy that Krugman’s useful economics needs to reckon with, one that Keynes and after him George Soros, emphasized. Along with uncertainty, the economy exhibits pervasive reflexivity: expectations about the economic future tend to actually shift that future. This will be true whether those expectations are those of speculators, regulators, even garden-variety consumers and producers. Reflexiveness is everywhere in the economy, though it is only easily detectable when it goes to extremes, as in bubbles and busts, or regulatory capture …

When combined uncertainty and reflexivity greatly limit the power of maximizing and equilibrium to do useful economics … Between them, they make the economy a moving target for the economist. Models get into people’s heads and change their behavior, usually in ways that undermine the model’s usefulness to predict.

Which models do this and how they work is not a matter of quantifiable risk, but radical uncertainty …

Between them reflexivity and uncertainty make economics into a retrospective, historical science, one whose models—simple or complex—are continually made obsolete by events, and so cannot be improved in the direction of greater predictive power, even by more complication. The way expectations reflexively drive future economic events, and are driven by past ones, is constantly being changed by the intervention of unexpected, uncertain, exogenous ones.

Alex Rosenberg

[h/t Jan Milch]

7 Comments

  1. “If uncertainty is an ever present, pervasive feature of the economy, ”

    But these risks are usually not of economic nature: they are geopolitical, political or even technological (flash crash). Which makes this a strawman argument. The conclusion is correct but for the wrong reasons:

    “Between them reflexivity and uncertainty make economics into a retrospective, historical science, one whose models—simple or complex—are continually made obsolete by events, and so cannot be improved in the direction of greater predictive power, even by more complication. The way expectations reflexively drive future economic events, and are driven by past ones, is constantly being changed by the intervention of unexpected, uncertain, exogenous ones.”

    The statement that economics is a “retrospective, historical science” is certainly correct and this reinforces my position that economic departments should be eliminated because they only offer hindsight and ideology.

    http://www.digitalcosmology.com/Blog/2014/02/12/a-call-to-action-abolish-economics-departments-now/

  2. Hello Lars,
    You wrote:
    “Keynes famously argued that classical economics had no role for money just because it didn’t allow for uncertainty.”

    Could You give a short hint how Keynes came to that conclusion?

    Best regards from germany
    Siegfried

  3. On man som icke-ekonom vill läsa och kanske även rekommendera en relativt kort akademisk introduktionsbok till ekonomiämnet idag, vilken förslår du då? Jag har ögnat på Ha-Joon Changs nyutkomna “Economics: The User’s Guide”. Har du andra förslag?

    • Steve Keens Debunking economics är bra (men förutsätter nog att man läst lite ekonomi innan).

    • Till “E”: “Lilla boken med stora tankar om ekonomi”
      av Mathew Forstater är enkel och lättfattlig introduktion tycker jag och Lars är klädsamt blygsam nog, att inte rekommendera någon av sina egna böcker, men låt mig då jag göra det, “De ekonomiska teoriernas historia” av Lars Pålsson Syll, himself,är en utmärkt och välskriven introduktion i ekonomi ämnet och dess utveckling.God läsning E !


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