Modelling an uncertain world

9 March, 2019 at 14:56 | Posted in Economics | 2 Comments

In a very personal discussion of uncertainty and the hopelessness of accurately modeling what will happen in the real world, Nobel laureate Kenneth Arrow – in “I Know a Hawk From a Handsaw,” in M. Szenberg, ed., Eminent Economists: Their Life Philosophies, Cambridge University Press (1992) – writes:

It is my view that most individuals underestimate the uncertainty of the world. This is almost as true of economists and other specialists as it is of the lay public. To me our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness … Experience during World War II as a weather forecaster added the news that the natural world as also unpredictable. cloudsAn incident illustrates both uncertainty and the unwillingness to entertain it. Some of my colleagues had the responsibility of preparing long-range weather forecasts, i.e., for the following month. The statisticians among us subjected these forecasts to verification and found they differed in no way from chance. The forecasters themselves were convinced and requested that the forecasts be discontinued. The reply read approximately like this: ‘The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.’

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  1. Wonderfully ironically true and funny.

  2. Finance deals with uncertainty through hedging. You can hedge away weather. You bet that it will be sunny; I take the opposite side; we both take out insurance and the loser gets the insurance to pay. The insurance companies can themselves be fully matched book. Thus the physical uncertainty of weather can be financially hedged away. That is how Goldman Sachs and JP Morgan have made money through many uncertain times; they know how to hedge perfectly and write contracts that they can sell, which hedge the weather for farmers.


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